There are five principal risks in investing in annuities:
- Market Risk
- Inflation Risk
- Company Risk
- Tax Risk
- Liquidity Risk
Market risk. If you purchase a variable annuity, you run the risk of the underlying investments performing poorly. This risk is balanced by the potential of receiving a higher return than would be possible with a fixed return investment. Variable annuities may also offer a low, but important guaranteed minimum return.
Inflation risk. If you purchase a fixed annuity, you are guaranteed a fixed return from the insurance company. Nevertheless, if your guaranteed return fails to keep pace or exceed the inflation rate, you will essentially be losing purchasing power.
Company risk. Your annuity is only as good as the insurance company issuing it. Though some states have guarantee funds to reimburse policyholders of failed insurance companies, it makes sense to buy from companies with strong financial ratings from one or more of the major ratings companies.
Tax risk. You will probably be in a lower tax bracket when you retire and begin receiving your annuity income, but there is no guarantee of it. By the time you retire, tax rates may have risen, saddling you with a higher tax bill than you would have paid had you taken your investment income earlier.
Liquidity risk. Deferred annuities are designed to be long-term investments. Once you invest in them, you should count on not having to use that money until you reach age 59 1/2. If you withdraw your money before then, you may incur a surrender charge from the insurance company (except for withdrawals of limited amounts) and a tax penalty of 10% levied by the IRS. In addition, you will have to pay income tax on any profit you may have earned up to that point.