4 Annuity Risks and How to Avoid Them

Written by Hersh Stern Updated Thursday, November 14, 2024

If you’re looking to purchase an annuity as part of your retirement plan, you are likely looking forward to tax-deferred growth, followed by a guaranteed stream of income and of course peace of mind. These advantages are very real, and may make a deferrred annuity a good choice for you.

But before you buy, be sure to consider that there are some drawbacks and disadvantages to annuities 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. Thereafter, you will be restricted from getting a refund of your principal without hefty surrender penalties.

For those contracts that do allow withdrawals, the amounts may be limited to a few percent up to 10% a year. For this reason, only buy an annuity if your financial needs are covered and you have adequate ready cash.

There are sometimes exceptions to the withdrawal penalties for medical emergency or hardship, but understand and accept the details of your specific contract.

2. Company risk

Above all, choose an insurance company with a very solid financial foundation. Your account value and future income under your 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 AM Best that rate the stability of insurers.

Beware of the higher interest rates 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.

3. 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, an annuity may give you secure base to give you more comfort when taking more risks with other parts of your investment portfolio.

4. Interest rate risk

Interest rates have been dropping for more than 30 years, and this certainly factors into the returns 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.