Most of the information available on annuities today emphasizes their record of safety and their role as an asset and income safety net in the context of an overall financial plan. And, while there are many reasons to trumpet their advantages and benefits, owning annuities doesn’t come without some risk. On the risk-reward spectrum, all investments entail some sort of risk. Understanding annuities and how they work in relation to your own specific needs, priorities, and tolerance for risk will help to expose what risks, if any, they present to you.

Liquidity Risk

Perhaps the biggest risk factor associated with annuities is the restriction on access to funds. Although annuities do allow for complete access through surrendering the contract, the fees and penalties that could be triggered could adversely impact the principal amount. An investment in an annuity needs to be made with the knowledge that it is a long term investment which may not perform to expectations if funds are accessed too early in the contract.

Annuities should not be considered if there is not a sufficient amount of liquid assets available elsewhere in your portfolio. Still, they do allow for partial access through a once-annual withdrawal of up to 10% of your account balance without incurring a fee. A surrender fee, ranging from 5% to 12%, is charged on any withdrawal that exceeds 10% in a year during the contract’s surrender period. Because the fee gradually declines throughout the surrender period, they eventually vanish.

Market Risk

Anytime your assets are exposed to the fluctuations of a market, such as stocks or bonds, they are subject to market risk, which means they could lose value. Market risk is not an issue for fixed annuities as the rate of return is based on a fixed yield and supported by rate guarantees. But, with variable annuities, which include separate investment accounts, the risk of fluctuation in the value of the accounts is tied directly to the performance of the markets. Indexed annuities, while linked to the movement of stock indexes, provide enough downside protection that market risk is not a concern.

For investors who have low or no tolerance for market risk, fixed or indexed annuities are the most suitable investment choices. Some variable annuities offer the option to purchase a minimum rate guarantee which would ensure that, even in market declines, your account value will receive some positive rate of return.

Interest Rate Risk

The risk of interest rate movement affects all annuities in some way or another. For fixed annuities, especially those with a multi-year rate guarantee, the risk is that interest rates rise quickly while your funds are locked into a lower yield. Conversely, if your rate is guaranteed for just one year, the risk is that interest rates suddenly fall, and your renewed rate is lower than your initial rate.

Interest rate movements also affect the stock and bond markets. If you own a variable annuity with funds invested in stock and bond accounts, an increase in interest rates could cause those markets to decline. The best risk mitigation strategy is to have a balanced and diversified allocation strategy so that any movement in interest rate will only adversely affect one part of your portfolio.

Inflation Risk

The risk of inflation affects the long term impact of your annuity accumulation, and ultimately, the purchasing power of future annuity income. In terms of its devaluing capabilities, a dollar today will be worth half as much in 20 years based on the current rate of inflation. Should the rate of inflation increase, that timeframe will shorten. This puts any portfolio that isn’t properly invested as a hedge against inflation at risk. While the owners of fixed annuities may enjoy the current comfort of having no market risk, the risk of inflation can have even more devastating consequences. Only a properly balance and diversified portfolio of varying asset classes can provide the essential offset to inflation.

Taxation Risk

There are two types of taxation risk associated with owning annuities. The first has to do with the potential tax consequences of the annuity contract itself. The big advantage of annuities it the tax deferral of earnings within the contract. They are then taxed when withdrawn at retirement. One of the planning theories behind owning annuities is that your tax bracket is higher while you are accumulating earnings, and then it drops after retirement so that you will pay fewer taxes on the annuity withdrawals. The risk is that your bracket remains the same, or, due to an unforeseen change in the tax law, it increases. It still doesn’t erase the impact that tax deferred earnings had over the years on your accumulation.

The second kind of taxation risk it the possibility that changes in the tax law could impact the tax treatment of annuities in the future. Although it’s not mandated, most tax law changes that affect investments include a “grandfather” provision which protects existing investments.

Credit Risk

Annuity contracts and all of their guarantees and obligations are backed strictly by the assets of the issuing life insurance company. Perhaps the greatest risk an annuity owner faces is that the issuing life insurer runs into financial trouble or becomes insolvent. It is also important to note, however, that this risk has yet to materialize to the extent that an annuity owner has ever lost any money. While there have been some instance of insolvency, the collective strength of the life insurance industry has, time and again, come to the fore to rescue the policyholders of a diminished life insurer.

Any degree of credit risk can be reduced, if not eliminated, by investing in annuities issued by the most credit worthy life insurers who meet the stringent standards of independent rating companies. The most highly rated companies have the strongest balance sheets and are deemed to be resistant to economic cycles.

Summary

For any one investment, there really is no way to get around risk. It comes in many different forms, and some forms are less obvious, but potentially more destructive than others. Annuities are inherently low risk investments; however, to limit your allocation to one type of annuity could actually increase your exposure to risk. One of the most effective risk reduction strategies is to own a portfolio of annuities that can counter the different exposures to risk. A portfolio consisting of a variable contract (or two), an indexed annuity and a fixed annuity, would provide enough countering effects to minimize any type of risk.