How Safe Are Annuities?
Several layers of insurance and guarantees make annuities a safe investment and retirement option. Read about types of annuities and the various levels of risk they carry.
There are many levels of safety built around annuities. First, the safety of annuities depends on the type of contract, such as interest-rate guarantees or simply a guarantee not to lose money. Annuities are also issued and backed by insurance companies, so the strength of the company comes into play because it's the insurance company making a promise to the investor. Finally, each state's guaranty association backs up the promises made insurance companies that do business in its state.
Immediate annuities allow a person to invest a lump sum of money with an annuity provider and in return receive an income guaranteed for a certain period of time, typically from five years up to the rest of the annuitant's life and spouse's life. The income from the annuity is guaranteed by the annuity provider and is not dependent on stock market or interest rate risk. The issuing insurance company must pay the stated income each month or each year as promised, no matter the economic environment.
Fixed Deferred Annuities
A fixed deferred annuity is a retirement account in which a person rolls a lump sum of money into an annuity or invests periodically. Fixed deferred annuities fall into one of two categories, either traditional fixed annuities or fixed index annuities. Fixed and fixed index annuities are safe in that the account value is guaranteed by the annuity provider not to ever lose money. A traditional fixed annuity pays a minimum-guaranteed interest each year on the account value. A fixed index annuity pays an interest rate each year based on an underlying index, such as the Standard & Poor's (S&P) 500. The minimum guarantee of a fixed index annuity is zero percent, even if the underlying index loses money over the course of the year.
Deferred Variable Annuities
Deferred variable annuities are much like fixed deferred annuities with the exception of one big component: they do not carry any account value guarantees. The account value of a deferred variable annuity performs based on investment divisions that mirror mutual funds that are chosen by the investor. If the mutual funds perform well, then the investment divisions credit the account value accordingly. However, if the mutual funds do not perform well, then the corresponding investment divisions will lose money. You literally can lose all your money with a variable annuity.
Insurance Company Strength
Annuities are as safe as the insurance company that issues them. Unlike CDs, which are backed by the Federal Deposit Insurance Corporation, annuities are backed by the full faith and promise of the annuity provider. It's vitally important for every investor to know how strong the annuity provider they are considering actually is. For this reason, four third-party independent rating organizations exist to watch insurance companies carefully and report back on their financial strength. These four companies are A.M. Best, Moody's, S&P and Fitch (see Resources). These organization publish the financials of each insurance company and issue ratings based on how well they are positioned for the future.
Insurance Company Insolvency
Each state has a guaranty association that exists to protect the policy holders of life insurance and annuities in case the insurance company fails to deliver on its promises. Laws require each insurance company to be a member of each state's guaranty association they wish to do business in. If an insurance company becomes insolvent--or unable to make its claims--the guaranty association for that state kicks in to provide the owner or beneficiary the money he was promised. Guaranty associations do not cover any portion of a life insurance policy or annuity that carries investment risk taken on by the owner, such as a variable annuity. The guaranty association exists to back up the guarantees made by the insurance company that has failed. Each state protects policy holders in different amounts, ranging from $100,000 to $500,000.
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