Annuity Risks

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Witten By Nikhil Bhauwala

2 min read

Posted - Sat Jan 06 2024

As I approach retirement, understanding annuity rates becomes crucial. The annuity rate report provided me with the knowledge to compare and choose the best rates, empowering me to maximize my savings and secure a financially sound future.

Les Balmer

Recently retired. Dallas,Texas

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Understanding Annuities

An annuity, a distinct form of investment, diverges from other high-risk financial products since its stability remains mostly impervious to stock market fluctuations. Instead, these reliable investments rest securely in funds like publicly-traded companies’ stocks, bonds, or money market funds.

Contrary to producing a rate of return, annuities serve as income products, supplementing your earnings with a “salary” of sorts. These payments can be disbursed in various frequencies—monthly, quarterly, semi-annually, or annually. While some annuities commence payments immediately, others, known as deferred annuities, initiate payouts at a later time.

Contrary to producing a rate of return, annuities serve as income products, supplementing your earnings with a “salary” of sorts. These payments can be disbursed in various frequencies—monthly, quarterly, semi-annually, or annually. While some annuities commence payments immediately, others, known as deferred annuities, initiate payouts at a later time.

Bear in mind, though annuities embody lower risk investments, they aren’t entirely risk-free. In fact, income annuities encompass several types—fixed, variable, and indexed annuities. Among these, fixed annuities pose the least risk, whereas variable annuities present greater risk but with the potential for higher returns.

Annuities, akin to insurance policies, fall under the jurisdiction of state regulations. Consequently, you must purchase an annuity through a licensed agent. Prior to investing, carefully weigh the risks and benefits associated with annuities to make an informed decision.

Different Types of Risks

  • Market Risk There are risks involved with all types of investments, and annuities are no different. First, there is market risk. Market risk is when the growth rate changes based upon the stock market. Although all annuities are not associated with the stock market, some are. This includes equity-indexed or variable annuities. When you invest in this type of annuity, you risk a lower return or even loss when the market fluctuates.
  • Inflation Risk Inflation is another risk factor when it comes to investing in an annuity. With annuities being a more conservative investment, they sometimes cannot keep up with the cost of living. This simply means that the amount you receive monthly one year might not be able to cover your expenses in future years. You are more prone to this type of risk when you invest in a fixed annuity that has a fixed rate.
  • Comparing Risks Inflation is another risk factor when it comes to investing in an annuity. With annuities being a more conservative investment, they sometimes cannot keep up with the cost of living. This simply means that the amount you receive monthly one year might not be able to cover your expenses in future years. You are more prone to this type of risk when you invest in a fixed annuity that has a fixed rate.
  • Longevity Risk Many struggle to decide when to retire. This is because of longevity risk. Longevity risk happens when you outlive your money. An annuity offers an income for life. The exception is when the investor lives a really long time, then the annuity payment might actually decrease over time. Immediate annuities, deferred income annuities or longevity annuities are a few examples of annuities with longevity risk.

The Pluses of Annuities

An annuity can provide you with a solid retirement income. This amount is for life making it an income you can depend on. You can put unlimited funds in your annuity so there are no caps. Therefore, individuals who have a lump sum of money that they want to safely invest, might want to consider an annuity.

The Minuses of Annuities

An annuity can be viewed as a conservative investment. Therefore, investing in an annuity will not result in large stock gains. Also, if you have an emergency, you cannot withdraw money from your annuity early (or during the surrender period) without being charged a penalty. This penalty is known as a surrender charge and can adversely affect your gains.

Annuities, as tax-sheltered investments, may leave you wondering about the implications for you, the investor. Investing in a tax-sheltered vehicle like an annuity allows your funds to grow without being taxed until you either withdraw or receive them, ultimately bolstering your retirement savings.

The taxes you owe hinge significantly on how your financial advisor structures your annuity account. For instance, if established as a qualified annuity—funded with pre-tax dollars, such as those from an IRA—your funds become fully taxable. Conversely, with a non-qualified annuity, one purchased using post-tax funds, taxes apply solely to your earnings.

Estate planning also plays a crucial role in how you set up your account. Ensure that you designate a beneficiary upon establishing your annuity, as this individual or organization inherits ownership upon your demise. Beneficiaries may include one or more persons or even charitable organizations.

Getting the Best Out of Your Annuity

Investing in an annuity is a smart choice. However, it is most beneficial when it is part of a more diverse portfolio. You should consider pairing your annuity with other investments like mutual funds, corporate bonds and exchange-traded funds for the best results. To better protect your investments, you should also consider annuity laddering which involves scattered purchasing of annuities over years. The result is the ownership of a variety of annuities at different rates and with varying maturity dates which fluctuates your pay out dates. Lastly, if you cannot afford to take risks, talk to your financial advisor about a hedging arrangement to lower your risk factor.

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Conclusion

Investing in an annuity is one way to increase your retirement income. It is also a simple way to shelter your money from taxes while building a nest egg for the future. Investing in annuities, however, is not completely foolproof. It involves risks related to inflation, longevity and market. As with all investments, it is important to understand the benefits as well as the risks associated with annuities before signing.