Annuities are among the safest financial instruments available, but they are not without danger. If you’re considering purchasing an income annuity for your retirement plan, you’re probably looking forward to a lifetime guaranteed source of income and peace of mind. These benefits are the real deal, and investment in annuities may be an excellent option. However, consider several downsides and disadvantages to an income annuity before you buy. One of the most significant dangers to an annuity is indeed death, but other external dangers like liquidity exist. You can mitigate the impact that some of them have if you plan ahead of time. Here are some of the biggest threats to annuities.
1. Illiquidity
Annuities are among the most illiquid contracts, and withdrawals are frequently subject to steep penalties. Most annuities bind you to the contract when the initial “free look” period expires. You’ll be restricted or prevented from receiving a return from your principal after this period. The costs and penalties for providers that offer a one-time limited discretionary withdrawal are always high. As such, it’s essential only to purchase an annuity if you have sufficient ready cash after paying the insurance company’s premium.
2. Premature Death
If you die too soon after purchasing an income annuity, you will not enjoy the benefit of the planned future payments. This risk is common to all types of insurance, and it is the price you pay for the security of knowing that your income stream will be guaranteed no matter how long you live.
3. Business risk
Above all, choose an insurance provider that has a sound financial foundation. Your future payout from your income annuity is contingent on the insurer remaining healthy for many years and decades. Fortunately, many states have guaranteed funds to safeguard annuity holders in the event of insurer collapse, so this is a relatively rare occurrence. Nonetheless, your best bet is to choose an insurer with high ratings from groups that rate insurers’ stability, such as A.M. Best or Standard & Poor’s. If an annuity firm goes bankrupt, it is not regulated by FINRA, and state and municipal insurance agencies only cover damages of $250,000-500,000. So if you are concerned about losses, divide your annuities among different insurers to be under coverage limits.
4. Inflation
You will most likely rely on your annuity for income for many years to come. Consider how rising inflation may lower the spending power of such payments in the future. You may wish to consider adding a rider to adjust your annuity benefit for inflation (at an additional expense) so that rising inflation does not undermine the value of your annuity payments.
5. Loss of opportunity
An annuity can be a valuable part of your retirement strategy, and the peace it provides is invaluable to many people. However, keep in mind that the money you put into an annuity is not available for most types of investments. As with any long-term financial decision, there is a chance that you could’ve done better if you had invested your money elsewhere. It is impossible to foresee how the future will unfold as you approach retirement. Hence, a more diversified portfolio is typically your best bet. Holding an income annuity may provide you with a safe enough base income stream to feel comfortable taking chances with other areas of your financial portfolio.
6. Interest Rate Risk
For more than 30 years, interest rates have been falling, which has undoubtedly influenced insurers’ payouts on annuities. Low-interest rates limit insurance firms’ returns and their ability to pay. Consider laddering your annuity purchases over several years if you are concerned about purchasing an annuity when interest rates are low. Regardless of what you hear, the future is unpredictable. While interest rates appear to be low already, they may fall even further. Assess the interest rate risk concerning the hardship that could result from a worst-case scenario, and be sure you’re willing to give up some potential upside for the peace of mind of knowing your necessities are met right now.
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