How Risky Are Annuities?
An annuity is often a component of a retirement plan. The annuity pays the holder according to a schedule, such as once a month. The annuity usually provides payments for the life of the holder, so it is risky for an investor to purchase one if the investor does not expect to live much longer. Annuity risk varies depending on the type of annuity the investor buys, and the insurance company that sells the annuity.
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Fixed Annuity
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A fixed annuity is relatively safe. The investor buys the annuity and the insurance company must make a payment on each date on the schedule. The payment value does not change. According to the state of Utah, one of the main risks of a fixed annuity is that the insurance company will go bankrupt, although that risk is also present with the other, riskier types of annuities. Inflation will reduce the buying power of a fixed cash payment.
Variable Annuity
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A variable annuity is riskier than a fixed annuity. If the insurance company uses the performance of a stock portfolio to determine the payout, the annuity includes the risks inherent in purchasing stocks. Stocks are riskier than bonds and other investments, although they do provide more potential for gain. A variable annuity can be based on bond value, including the risk of purchasing a bond. The risk of the underlying assets determines the risk of a variable annuity, and the annuity will become worthless if the investments do.
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Insurance Company Risk
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When an insurance company sells annuities, the insurance company has a rating from a credit reporting agency. This rating tells annuity buyers how likely it is that the insurance company will stop paying out on an annuity, so an insurance company with a low rating has to pay out more to attract clients. If a bank representative offers a bank customer the option to buy an annuity that an insurance company offers, the bank must warn the customer that this is a contract between the customer and the insurance company, not the bank, according to the Treasury.
Investor Risk
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The risk of an annuity also depends on the investor's financial standing. According to the Treasury, a bank representative should consider whether the investor holds another policy, such as life insurance, and whether the investor will be able to afford to buy the annuity. According to the state of Utah, some annuities include an accumulation period during which the investor must make regular payments to build up the value of the annuity. The investor may have trouble paying all of the installments.
Liquidity Risk
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Liquidity risk is a major factor with an annuity. An annuity is usually a purchase to provide income in retirement. Even if the annuity includes the potential for short-term gains, such as a variable annuity that depends on stock, the investor will face withdrawal penalties for cashing out the annuity early. These additional withdrawal penalties can include additional tax liabilities. An annuity should be only a long-term financial decision.
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