6 Annuity Risks and How to Avoid Them

Written by Hersh Stern Updated Friday, July 13, 2018

If you’re thinking about buying an income annuity as part of your retirement plan, you are likely looking forward to a lifelong guaranteed stream of income and, of course, peace of mind. These advantages are very real, and may make an annuity a good choice for you.

But before you buy, be sure to consider that there are some drawbacks and disadvantages to an income annuity, be it an immediate or deferred income, that you should weigh. With some planning, you can control the impact that these risks could have on you.

1. Illiquidity

With most annuities, you are committed to the contract at the end of the initial "free look" period. After this period you will be restricted or barred from getting a refund of your principal.

For those companies which do allow a one-time limited discretionary withdrawal, the costs and penalties can hurt. For this reason, only buy an annuity if you have adequate ready cash after you've paid the premium to the insurance company.

2. Dying early

If you die too soon after buying an income annuity, you will not receive the benefit of the future payments you had expected. This risk is common to all sorts of insurance, and it’s the tradeoff for the security of knowing that no matter how long you live, your income stream is guaranteed.

Most of my clients accept this risk because they value the security more highly, but be sure to think this risk through and understand its implications for your beneficiaries.

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3. Company risk

Above all, choose an insurance company with a very solid financial foundation. Your future income under your income annuity depends on the insurer staying sound and healthy for many years and decades to come.

Fortunately, most states have guarantee funds that protect annuity holders in the event of insurer failure, so this problem is very rare. Nevertheless, your best choice is to choose an insurer with strong ratings from companies like A.M. Best or Standard and Poor’s that rate the stability of insurers.

Beware of the higher payouts that lower-ranked companies may offer – this is rarely a good trade off. State coverage has dollar-amount limitations, so if you are worried about losses, spread your annuities among multiple insurers to remain within coverage limits.

4. Inflation

You will likely look to your annuity to provide income for many years and decades to come. Be sure to consider how rising inflation can reduce the spending power of those payments down the road.

You may want to elect a rider that adjusts your annuity benefit for inflation (although this will incur an additional cost), so that rising inflation does not erode the value of your annuity payments.

5. Opportunity cost

An annuity can be an important piece of your retirement plan, and the peace of mind it provides is priceless for many people. Nevertheless, remember that the money you commit to an annuity will not be available for other types of investments.

As with any long-term financial choice, you face a risk that you could have done better if you had put your money elsewhere. As you near retirement, a diversified portfolio is usually your best bet since it is impossible to predict how the future will unfold.

In fact, owning an income annuity may give you a secure enough base income stream that you'll be comfortable when taking more risks with other parts of your investment portfolio.

6. Interest rate risk

Interest rates have been dropping for more than 30 years, and this certainly factors into the payouts that insurers are offering on annuities. Low interest rates cap the insurance companies' returns and the amount they can pay.

If you are worried about buying an annuity when rates are low, consider spreading your annuity purchases over a number of years in a strategy called laddering. Despite any prognostications you may hear, the future is unpredictable.

While interest rates seem low already, they could fall further as they have in Japan. Weigh the interest rate risk against the hardship that might be created by a worse-case scenario, and be sure you feel comfortable giving up some upside potential for the peace of mind in knowing your needs are secured right now.

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