Are Annuities Safe?

Retirees often consider annuities as a good way to generate income in retirement. In fact, an annuity can provide income that you cannot outlive. But they can be complicated – and expensive – so it’s important to understand how they work and if they’re right for you.

Read More: 5 Genius Things All Wealthy People Do With Their Money

A common question about annuities is whether they are safe. Here’s what you need to know.

What Is an Annuity?

An annuity is a contract between an insurance company and an individual. The individual pays the company a certain amount of money, either in one lump sum or periodic payments. In exchange, the company pays the individual a series of payments, typically for the rest of the person’s life.

The annuity may earn interest, in the case of a fixed annuity, or investment returns, in the case of a variable or indexed annuity.

The amount of the payments made depends on the amount invested, the length of time the money is invested, and the age of the person when they start taking payments. Typically, once the person begins taking payments, they continue for their entire life, but no longer. There are some annuities that provide a death benefit if the total of the payments is less than the value of the contract, but not all provide this option.

Will I Get All My Money from an Annuity Back?

The answer to this question depends on a lot of different factors.

Annuities have two phases: the accumulation phase, when you are depositing money into the annuity, and the payout phase, when you are taking money out.

The Accumulation Phase

If you withdraw the funds from your annuity while you are in the accumulation phase, you will get at least some of your money back. Because annuities are meant to be a long-term investment, most annuities have a surrender charge — a percentage of the amount you put in that you will not get back. This percentage usually declines over time, so if your annuity has a 7-year surrender charge, you might be charged 7% if you take your money out in the first year, 6% in the second year, 5% in the third year, and so on. After the seventh year, there is no surrender charge.

If you die during the accumulation phase, your heirs will get the contract value of your annuity as an inheritance.

The Payout Phase

Once you enter the payout phase, things change. When you begin taking payments, you will usually annuitize the contract. This means that the contract is no longer a lump sum amount, but a series of payments that will last until your death.

Suppose you have an annuity with a value of $500,000 and you annuitize it. Your monthly payments are $5,000. If you take two payments and then die, you will have gotten $10,000 back from your $500,000 contract. This may include principle plus gains. Your heirs, unfortunately, get nothing.

If, on the other hand, you live another 10 years, you will have collected $600,000, even though your contract was only worth $500,000. And if you lived 15 years, you’d collect $900,000.

In some cases, an annuity will have optional features that will provide other options. You may be able to specify a period of time in which payments are made, which is called a “period certain,” so even if you die, your heirs continue to collect for that period.

Some annuities allow you to withdraw periodic payments without annuitizing. If you have this option, be sure you understand the pros and cons of each method before you decide. You’ll want to weigh the amount you’ll get each month under each method, as well as what will happen with any remaining balance in the account when you pass away.

What if the Market Goes Down?

Variable annuities can fluctuate in value because the principle is invested in mutual funds and other variable investments. Many annuities have an option, called a “rider,” which will preserve your death benefit or your income payments in the event of a market downturn. In other words, you would get income based on the highest value, regardless of the current contract value at the time you begin taking payments. This is called a guaranteed minimum income benefit, often abbreviated GMIB, or some similar name.

The same may be true for the death benefit, meaning that your heirs would receive the highest contract value amount if you die before taking payments. If you die after beginning payments and your contract has a death benefit, your beneficiaries may receive the highest value less any withdrawals.

The riders that guarantee the higher value even if the market declines are complicated and can be expensive. Be sure you understand what they will cost you and what you are getting for your money.

What Happens if the Annuity Company Fails?

Like a life insurance policy, your annuity is only as good as the company you buy it from – sort of. The annuity contract is backed by the insurance company that issues it and, unlike a bank deposit, it is not FDIC-insured.

That doesn’t mean you’re entirely out of luck if your annuity provider fails, however. Annuity owners are protected by guaranty associations that will pay out in the event of an annuity provider failure. There’s a guaranty association in each state. Depending on how much you have invested, however, you may not be made completely whole. There are limits to the amount a guaranty association will pay, and it’s usually about $100,000 per policy.

That said, you’ll want to choose an annuity provider that has been around for a long time and has a good reputation.

Good retirement planning is important, and safety is critical. That’s why it’s important to factor in the safety of any investment you are considering, and annuities are no exception to this important rule. Annuities tend to be on the safer side of investments, as long as you don’t need to unexpectedly withdraw the money early. And as far as providing income you can’t outlive, an annuity is the best choice for that.

FAQ

• What happens to an annuity if the market crashes?

  • Annuities have some advantages in times of market volatility. If you are in the accumulation phase, where you have not yet begun taking payments from the contract, you may have some protection against market declines. If you are in the payout phase, your monthly payments will not be affected - the amount is set at annuitization and won't change.

• What are the disadvantages of annuities?

  • Annuities have high fees relative to other types of investments, including administrative fees, mortality and expense charges, since they are an insurance product, and high commissions. One of the biggest disadvantages is the surrender charge. Annuities can charge up to 10% of the premium, or deposit, if you withdraw your money within the first year. This charge declines over time, and most annuities have no surrender charge after ten years.

• What is the biggest risk associated with annuities?

  • The biggest risk is that you will need to take the money out early and will incur a surrender charge. A surrender charge is the penalty you take for early withdrawals. It can be as much as 10% the first year, and typically declines over time, dropping to zero by year ten or earlier.

This article originally appeared on GOBankingRates.com: Are Annuities Safe?