Are Annuities Safe to Invest In?

There are many financial products you can choose to invest in as a part of your retirement portfolio. One of the most complex is an annuity. With annuities, you pay premiums to an insurance company in exchange for future payments or other benefits in the contract. Certain annuities offer guaranteed retirement income, while others have investment-related risks. Generally speaking, some types of annuities offer relatively strong protections against market losses. However, you do have to be careful and make sure you’re buying the right products from financial institutions you trust.

A financial advisor can walk you through the different options for meeting your retirement needs and goals.

What Are Annuities?

An annuity is a contract you sign with an insurance company where you pay one or more premiums in exchange for future payments or other contractual benefits, often during retirement. Annuities are popular with retirement investors because certain contracts provide guaranteed income during retirement, essentially replacing the pension payments that many workers got in earlier eras.

Annuities can be a valuable component of a well-rounded financial plan, offering a unique blend of security and growth potential. There are many types of annuities, but generally, they fit into three broad categories:

Fixed annuities are the most popular type. This annuity typically guarantees a specified interest rate for a period of time and protects principal from market losses, subject to the contract’s terms and the insurer’s ability to meet its obligations. These are not very risky, but you don’t have the chance to see your money grow the way you might with a different investment.
Variable annuities have no guaranteed interest. Your principal is generally not guaranteed, and the contract’s value depends on the performance of the underlying investment options. Some contracts offer optional guarantees for an additional cost. Variable annuities have higher potential for return but also come with significant risk.
Fixed indexed annuities credit interest based partly on the performance of a specified market index, subject to contract features such as caps, participation rates or spreads. They generally protect principal from index-related losses, although surrender charges, withdrawals and the insurer’s financial condition can affect the amount you receive.

As with any financial product, it’s essential to assess your individual needs and consult with a financial advisor to determine if annuities align with your long-term goals. By doing so, you can make informed decisions about how an annuity fits into your retirement plan.

Are Annuities Safe?

A woman checking her portfolio on her computer.

An annuity’s safety depends on its contract terms, the type of annuity and the financial strength of the issuing insurance company. Annuities are not bank deposits and therefore are not insured by the FDIC. However, state life and health insurance guaranty associations provide limited protection for eligible annuity contracts if an insurer becomes insolvent. Coverage limits and eligibility rules vary by state.

Variable annuities are less safe than fixed annuities, as their account values can rise or fall with the performance of underlying investments. Unlike traditional fixed annuities, variable annuities generally do not guarantee the return of your principal. Optional riders may provide certain protections, but these often involve additional fees and restrictions. Even when an annuity provides guaranteed payments, inflation can reduce their purchasing power over time.

How to Pick the Right Annuity

When purchasing an annuity, the key to feeling safe in your investment is to pick a quality insurance company. Check the firm’s credit ratings: There are four credit rating agencies in the United States to look at: AM Best, Fitch, Moody’s and Standard & Poor’s. If a firm has a high rating from all of these, you can probably trust it. However, ratings are assessments of financial strength, not guarantees against insurer failure.

Beyond that, consider how much you can pay in premiums and what type of payments you want to get in retirement. For greater protection against market losses, look for a fixed annuity. If you’re willing to take a bit more risk, consider a variable option. Either way, getting the help of a financial advisor is a good idea.

One note when it comes to getting a financial advisor’s advice on annuities: Some advisors, commonly called fee-based advisors, can earn commissions for selling insurance products, including annuities. This gives them a financial incentive to sell you the annuity that will bag them the biggest commission, even if it isn’t the best choice for you. For advice without product sales commissions, find a fee-only advisor who does not earn commissions.

What Risks Can Affect an Annuity’s Safety?

Even when an annuity protects your principal or promises lifetime income, other risks can affect how much money you receive and when you can access it. Understanding these risks is important before signing a contract.

Insurer risk. Annuity guarantees depend on the insurance company’s ability to meet its obligations. Financial strength ratings can help you assess this risk, but they cannot eliminate it.
Liquidity risk. Many deferred annuities impose surrender charges if you withdraw more than a permitted amount during the surrender period. Some contracts also apply market value adjustments that can reduce the amount available when you withdraw funds early.
Market risk. Variable annuities expose investors to changes in the value of underlying investments. Fixed indexed annuities generally protect against negative index performance, but participation rates, caps and other contract terms can limit gains.
Inflation risk. A fixed payment may lose purchasing power over time. For example, a $2,000 monthly payment would have the purchasing power of approximately $1,488 after 10 years of 3% annual inflation, calculated as $2,000 ÷ 1.03¹⁰.
Fee risk. Certain annuities charge administrative fees, investment expenses and fees for optional benefits. These costs can reduce the contract’s value or investment returns.

Before buying, review the surrender schedule, withdrawal provisions, guaranteed benefits and applicable fees. These details can help you determine whether an annuity’s protections are worth the restrictions.

How to Plan for Retirement With an Annuity in Mind

When planning for retirement, considering an annuity can be a strategic move to provide a steady income stream during your golden years. Annuities are financial products offered by insurance companies that provide regular payments in exchange for an initial investment. They can be particularly appealing to those who want to mitigate the risk of outliving their savings.

Incorporating an annuity into your retirement plan can complement other investment vehicles, such as stocks, bonds, and real estate. Annuities can provide a guaranteed income, which can be a stabilizing factor in a diversified portfolio. This guaranteed income can help cover essential expenses, allowing you to take more calculated risks with other investments.

However, it’s crucial to balance the security of annuities with the growth potential of other assets to keep your investment portfolio adaptable to changing market conditions.

One of the key considerations when planning for retirement with an annuity is understanding the tax implications. Annuities offer tax-deferred growth, meaning you won’t pay taxes on the earnings until you start receiving payments. This can be advantageous if you expect to be in a lower tax bracket during retirement. However, it’s important to note that withdrawals before the age of 59½ may incur an additional 10% federal tax on the taxable portion, unless an exception applies. For nonqualified annuities purchased with after-tax funds, only the earnings portion of distributions is generally taxable. Annuities held in tax-deferred retirement accounts follow the applicable rules for those accounts.

Selecting the right annuity involves assessing your financial goals, risk tolerance and retirement timeline. Fixed annuities offer predictable payments, making them suitable for those seeking stability.

Bottom Line

The safety of an annuity can depend on the financial strength of the issuing company. It’s advisable to research the insurer’s ratings and reputation before committing to an investment. While annuities can provide guaranteed income under certain contract terms, they may not be suitable for everyone, particularly those who need liquidity or have a higher risk tolerance. Ultimately, whether annuities are a safe investment depends on individual financial goals and circumstances.

Financial Planning Tips

For more help with annuities, consider working with a professional financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Outside of annuities, you should make sure to use a workplace retirement plan like a 401(k) if you have access. Make sure you’re getting your full employer match if any is available!