Annuities have often been marketed as good investment vehicles for risk-averse investors, like retirees and other people who can’t afford to gamble with their money.
Annuities work such that the annuity holder makes a payment or a series of payments to the company offering the annuities, which then invests the money and in turn guarantees the annuity holder a lump-sum payment upon the maturity of the annuity or a steady flow of income for a lifetime (or up to a certain date) from the annuity. And while annuities are indeed relatively low risk investment vehicles, they nevertheless do carry an element of risk which the person taking them up should be aware of.
The element of risk in annuities is especially great in the case of a type of annuity called a variable annuity. In variable annuities, the rate of return from one’s annuities depends on the performance of the investments into which the annuity premium is put into. In this type of annuities, the annuity holder has a hand in choosing the investments into which his annuity premium is put.
Consequently, if the chosen investment performs poorly, the variable-rate annuity holder receives a diminishing or even no income from his annuity. And worse still, if the investment into which the annuity premium is invested fails completely, the annuity holder is at risk of losing his principal, that is, the actual money he bought the annuity premium with. The way to mitigate this risk is by making a prudent choice of investments into which your variable-rate annuity premium is put. Remember that a variable rate annuity is a gamble, and ensure that you don’t gamble with money that you can’t afford to lose (like your 401K).
Even in the case of fixed-rate annuities, which guarantee a steady stream of income for the annuity holder regardless of how well or poorly the underlying investment performs, the annuity holder should still be aware of the fact that these guarantees are in fact as strong as the company offering them.
Consequently, if the annuity company goes under, it also sinks with the annuity holder’s entire money. The way to mitigate this risk is by making a careful choice of an annuity company. Ensure that you go for an annuity company with strong fundamentals. And also ensure that you ask for full risk disclosure from the company which you opt to get your annuity from, and even more importantly, ensure that you read the risk disclosure critically and understand it and its full implications.