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:

As we just saw, variable annuities, both immediate and deferred, don’t protect your principal or give you any guarantees about how big your paychecks will be during the annuitization phase. Instead, they base the income on market performance because they invest your savings in stocks and bonds.

This means that there’s essentially the same risk of losing your money when buying a variable annuity as when investing directly in a mutual fund.

How to mitigate the risk?

You can protect yourself from losing money even with a variable annuity by adding a contract rider that guarantees a certain amount in withdrawals as income when you retire. This type of income-based rider will make the issuer have to pay you the agreed income even if the underlying portfolio decreases in value.

You can lose money with fixed income annuities if you die earlier than expected.

Fixed-income annuities guarantee you a certain income for life, no matter how long you live and whether or not you’ve spent your entire principal. Insurance companies manage to do this without losing money by pooling everyone’s savings into a single account and making precise estimations of how long annuity-holders are likely to live. Then, they’ll calculate the payments so that the principal will last exactly each holder’s average life expectancy.

Since it is an average, some people will live longer and come out winning, but others will die sooner, leaving the undistributed portion of their principal in the pooled account for the insurance company to keep. If you’re in the latter group that dies early, you effectively lose the unpaid portion. This is called the early death risk, and it’s one of the main disadvantages of single-life annuities.

How to mitigate the risk?

You can protect yourself from this type of loss by adding a rider to your contract to guarantee payments to your beneficiaries if you die early for an extra fee. This is called a death benefit rider, and it’s a way to bequest your savings to those you care for.

You can lose money to inflation with fixed income annuities.

Fixed-income annuities have a drawback: you will always receive the same income for the rest of your life or for whatever period the annuity contract specifies. After you reach the end of the annuity, or if you die exactly at the age the insurance company expects, you will have received back every dollar you originally invested in the annuity plus interests. In other words, your principal will be intact.

While this may sound exactly like what you would want, you have to consider inflation. Having the same number of dollars today as ten, fifteen or twenty years ago doesn’t mean you have the same amount of money because inflation makes today’s money less valuable than it was before.

So, with a fixed income annuity, as time goes by, your income loses value.

How to mitigate the risk?

Luckily, there’s a simple way to work around this, which is adding what is called a cost-of-living adjustment rider. This rider turns your fixed-income annuity into an inflation-indexed annuity tied to the CPI, which guarantees that your income will increase in proportion to inflation as time goes by.

You can lose money in surrender charges with deferred annuities if you withdraw early.

When you put your money in a deferred annuity, it is tied to the annuity by contract for a surrender period. If you need to access that money before the end of the surrender period, you’ll have to pay a penalty fee known as a surrender charge.

These early-withdrawal fees can make you lose a significant amount of money. They are highest when you initially make your deposit and decrease over time until they reach zero by the end of the surrender period.

How to mitigate the risk?

The way to avoid these charges is by not withdrawing your money until the end of the surrender period. Also, some contracts allow you to make small withdrawals annually without paying surrender charges. But if you want total access to your money whenever you need it, you can also opt-in for a no-surrender or level-load rider in exchange for a fee.

Annuities are tax-deferred investment vehicles for retirement, so the IRS imposes a penalty if you make withdrawals before you reach official retirement age. This fee is a hefty 10% of the early distribution amount. Additionally, remember that, early or not, you’ll also have to pay income tax on annuity distributions.

How to mitigate the risk?

The obvious solution is to wait until you’re 59½ to make any withdrawals, but sometimes that’s not an option. However, there are several exceptions to the 10% penalty, such as withdrawing to pay for medical expenses, medical insurance, college, purchasing your first home, covering expenses after the birth or adoption of a child, etc.

You can lose money with any type of annuity if the insurance company goes under

An annuity is a contract between you and an insurance company. And, like any other contract, it can be canceled by either party if something goes wrong.

Unfortunately, in the case of an insurance company going bankrupt, annuity holders are usually among the last to get their money back. This is because the insurance company’s assets are used to pay off its creditors first.

How to mitigate the risk?

The best way to protect yourself from this scenario is by choosing an insurance company with a good financial rating. You can check companies’ ratings at agencies like A.M. Best, Moody’s or Standard & Poor’s. Also, always read the fine print before signing any contract and make sure you understand what could happen if the company goes bankrupt.

The bottom line

An annuity can be a great way to save for retirement, but it’s important to understand the risks involved before deciding. By knowing what could happen if things go wrong, you can take steps to mitigate those risks and protect your money.

There are several ways you can lose money when you invest in an annuity. The highest risk comes with non-guaranteed variable annuities. However, you can also lose money with fixed income annuities by surrendering your contract early, with penalty fees for withdrawals before age 59½, and if the insurance company goes bankrupt. However, there are ways to protect yourself from each of these scenarios. By choosing an insurance company with a good financial rating and reading the fine print before signing any contract, you can minimize the risk of losing your money.

Originally published in ValueWalk.

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