In an annuity, you give a lump sum of money to the annuity company, usually an insurer, and it makes periodic payments to you. Many annuities are set up to coincide with your life expectancy, which is why insurers are natural annuity providers. The biggest long-term risk in buying an annuity isn't that you'll outlast your money -- it's that you'll outlast your insurance provider. As such, some annuity holders choose to hold multiple smaller annuities from multiple insurers instead of a large one from one insurer.
The Risk of Failure
Insurance companies don't fail very often, all things considered. Looking at a 40-year period ending in 2012, only 80 life and health insurance companies that do business in multiple states and 326 companies that work in only one state, failed, according to Bankrate. Between 2008 and 2012, only eight life insurance companies failed, according to Bankrate. Those eight failures represented less than $1 billion in liabilities, which is a very small fraction of the size of the bankruptcies that occurred elsewhere in the financial services sector during the same period.
Insurance Company Guarantees
If you are unlucky enough to buy an annuity from an insurer that fails, you enjoy some protection from your state's guarantee association. Unlike banks, which are federally insured, insurance companies in each state band together to form a state guaranty association that is privately funded. Under the requirements of the National Organization of Life and Health Insurance Guaranty Associations, each state's association offers at least $100,000 in insurance on an annuity's withdrawal and cash value, although your association may offer more. If your insurer fails, the association will make you whole, up its insurance limit or the value of your annuity, whichever is less.
The basic strategy behind spreading your risk is to purchase multiple annuities, each of which has a value below your state's maximum insurance benefit. This way, if any insurer fails, your annuity cash flow will only be partially interrupted. At the same time, you can also expect to get your principal balance back from the insurance guaranty fund. Purchasing annuities from insurers with strong financial strength ratings can also help to protect you from ever being impacted by a failure in the first place.
Other Risks of Loss
If you live long enough, a lifetime annuity can turn out to be a relatively good investment. The Wall Street Journal estimated that a 65-year old buying a lifetime annuity could expect to get 8.4 percent per year. If he lived to 100, that would be an excellent return for a guaranteed payment stream. However, if his annuity was tied to his lifetime and he died at 68, his estate would lose the money that he invested. Dividing the funds between insurers won't solve this problem -- but paying extra to have an annuity continue after you die might. Annuities that have fixed payments can also expose you to interest risk. While a $60,000-per-year payment might be enough to meet your expenses today, with 3 percent annual inflation, it'll only be worth about $30,000 in purchasing power in 24 years. One way to mitigate this risk is to purchase an annuity with increasing annual payments to counterbalance inflation.
- Jupiterimages/Creatas/Getty Images