The Risk of Investing in an Annuity

Annuities have often been marketed as good investment vehicles for risk-averse investors, like retirees and other people who can’t afford to gamble with their money. Annuities work such that the contract owner makes a payment or a series of payments to the insurer, which then invests the money and in turn guarantees a lump-sum payment upon the maturity of the annuity or a steady flow of income for a lifetime (or up to a certain date). And while annuities are indeed relatively low risk investment vehicles, they nevertheless do carry an element of risk which the person taking them up should be aware of.

The element of risk in annuities is especially great in the case of variable annuities. The rate of return from a variable annuity depends on the performance of the investments into which the premium is placed. The contract owner has a hand in choosing the investments into which the premium is put. Consequently, if the chosen investment performs poorly, the variable-rate annuity holder receives a diminishing income. And worse still, if the investment fails completely, the annuity holder is at risk of losing his principal, that is, the actual money he bought the annuity premium with. The way to mitigate this risk is by making a prudent choice of investments into which your variable-rate annuity premium is put. Remember that variable rate annuities are tied to market performance, so ensure that you’re don’t invest money you can’t afford to lose. (like your 401K).

Even in the case of fixed-rate annuities, which guarantee a steady stream of income for the contract owner regardless of how well or poorly the underlying investment performs, you should still be aware that these guarantees are only as strong as the company offering them. Consequently, if the insurer goes under, it also sinks the annuity account. The way to mitigate this risk is by making a careful choice of insurer. Ensure that you go for an annuity company with strong fundamentals. And also ensure that you ask for full risk disclosure from the company which you opt to get your annuity from, and even more importantly, ensure that you read the risk disclosure critically and understand it and its full implications.