By Jordan Bishop
If you’re nearing retirement or are already retired, chances are you’ve considered purchasing an annuity. An annuity can provide a guaranteed stream of income for life, which can be appealing when you’re trying to plan for your financial future. But like any investment, there’s always the potential to lose money with an annuity. So what should you know before investing in one? Here’s a look at the potential risks of investing in an annuity and how to mitigate them.
The risks of investing in an annuity
It may be odd to think you could lose money with an annuity, considering that they’re marketed as special guaranteed investments specifically designed to protect us from that outcome. This is a rather common misconception, however, because not all annuities are the same and not all of them come with the same level of principal protection.
That said, while it’s universally accepted that annuities are safer investment vehicles for retirement than other types of investments, that will largely depend on the type of annuity you purchase, the conditions of the contract you enter, and how financially strong the issuing insurance company that sells you the annuity is.
Quick overview of annuity types and how they work
In very general terms, there are two types of annuities, which are fixed annuities and variable annuities. Additionally, you may purchase either an immediate annuity that starts paying you right away or a deferred annuity that starts making payments later. Additionally, there are also fixed indexed annuities. Here’s a quick reminder of how all these work, but you can always check out other dedicated posts on the different types of annuities if you want more information.
- Immediate fixed income annuities: these are the simplest types of annuities. They work by turning a lump-sum payment into a guaranteed income for a preset period defined in an insurance contract. You can either choose to receive payments for a set number of years or for the rest of your life (the same way you would receive pension payments in different countries around the world), in which case payments are calculated based on how long the insurance company expects you’ll live.
- Deferred fixed income annuities: these work similarly to the previous annuities, but payments start after a preset number of years instead of right away. Your principal grows before the annuitization phase, usually at a guaranteed rate typically lower than that of a mutual fund.
- Immediate variable annuities: immediate variable annuities invest your principal in stocks and bonds, and you receive income based on how those investments perform. These types of products don’t offer principal protection and expose your investment to the market, offering the potential of higher returns in exchange for opening the door to risk. Unless you add some sort of income guarantee through a contract rider, an immediate variable annuity is no different from investing in the stock market with tax benefits, which means you can lose money.
- Deferred variable annuities: Like before, these work the same way as the immediate variable annuities, but you start receiving payouts later.
- Indexed annuities: Indexed annuities are the middle ground between fixed and variable annuities. Instead of investing your money in stocks or bonds, indexed annuities invest in a market-based index, usually the S&P 500. The return you earn is based on how well the index performs, but it’s capped at a certain level defined in the contract. If the market overperforms, the insurance company keeps the extra profit. On the other hand, indexed annuities also cap your losses, which means that if the market underperforms, the insurance company assumes liability for any losses.
After considering how the different types of annuities work, we can more easily understand the risks involved. There are six different ways you can lose money with the different types of annuities:
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