All investments contain risk. When people think of investment risk, they focus on the possibility of losing of money. People don’t like losing money, so conservative savers and investors will shy away from any type investment that may fluctuate in value. The most common example is the stock market. These people will put all their money in an annuity or bank CD, and tell themselves they are taking no risk. Let’s look at risk of these fixed investments, with particular emphasis on annuities.
Annuities and CD’s Avoid Loss of Principal
People keep massive amounts of money in bank CD’s. These assets have the full backing of the bank. If the bank should become insolvent, the FDIC will guarantee your assets up to $250,000. Essentially, there is no risk of losing money. People focus on FDIC insurance guarantees as the primary reason for keeping all their money in a bank.
Fixed annuities are not covered by the FDIC, or any other federal agency. This is the primary argument of bank officers when you are trying to compare buying a CD or a fixed annuity. So, on the surface, it appears that the owner of an annuity can only rely on the strength of the insurance company to guarantee his annuity payments many years into the future.
The above point is usually noted when financial planners tell you to look only at the strongest insurance companies. Technically this is true. However, an important consideration is how the insurance companies are regulated, which never seems to be advertised.
Insurance Companies are regulated by the state or states in which they are located, and in which they do business. Therefore, the largest insurance companies are regulated by all 50 states since they do business in those states. The important point is that each state has a mandated insurance fund into which all insurance companies in the state contribute. This fund is used to protect policyholders in case one of the insurance companies should become insolvent. The amount of insurance varies by state. The largest amount of protection is in the states of Washington and New York. These two funds protect up to $500,000 per policyholder.
Also, in most cases of insolvency, the state insurance commissioners request one or more of the other, stronger companies to step in and buy the assets of the insolvent company. This is routinely done, though it is not written into law that it must be done.
Given the above, the owner of an annuity offered by a top rated insurance company can feel safe that money will be there to pay his monthly payments when he retires. This is not a legal guarantee as with a bank CD, but in reality it is an extremely safe investment.
Of course, the situation is different with variable annuities. These annuities are designed to allow the contract owner to invest his money in various mutual funds, thereby having more potential for investment gain. While there are guarantees under these contracts, the contract owner does risk losing money and needs to aware of this risk.
Inflation Risk of Annuities
Bank CDs and fixed annuities all provide for a set interest rate to be credited to your account. This gives people comfort since they know that they are getting a set amount of interest that is guaranteed to be there when they retire. However, this fact comes with a cost. The cost is the loss of purchasing power over time. Inflation is always with us. Sometimes it is very high as it was in the 1970’s. Sometimes it is low, as it was from 2007 to 2011. We know inflation is occurring and usually voice the examples of the cost of gasoline and food to prove it. But overall inflation occurs slowly over time, so that we don’t even realize it is happening at a particular point in time.
No matter how old you are, think back to your teenage years and how much a car or house cost at the time. Even if you are relatively young, think about how much a can of soda or candy bar cost when you were growing up. The point is that prices have gone up and will continue to go up. Inflation is not an item that goes up and down like the stock market. It will always go up, unless the economy is in a particular deflationary period. This is not a normal event.
So, what is the effect of inflation on your fixed income investments? The value of your investment will not drop. However, inflation will cause you to lose purchasing power with those assets. If your annuity or CD is earning 4% and inflation is increasing at 3%, you essentially have real growth of only 1%. So, 20 years from now, your assets will not have grown much on a net basis. This is the reason professional managers and financial planners suggest putting your money in stocks. Stocks have more potential to outpace inflation.
On the other hand, the fixed rate of return from an annuity or CD is what you wanted when you made the investment. You like the certainty and guarantees. Annuities have the additional guarantee that you will receive your retirement payments for as long as you live. This guarantee under an annuity contract is extremely valuable and comforting.
The way you offset the inflation problem, yet still get guarantees, is to not put all your investments in one basket. The concept of diversifying your assets is a must. You should never have all your assets in one type of investment. This also goes for annuities. Put a good portion of your retirement money in a fixed annuity so you get payments for life. If you are covered under a pension plan, put less of your other assets into an annuity contract. You can then put your non-annuity assets into investments which will better outpace inflation. These investments should include a mixture of stocks, bonds, real estate and commodities.
Risk of Not Understanding the Investment
The risk of investing without understanding how the investment works is always a danger. If you invest in the stock market, you risk a severe loss if you do not understand the particular stocks or funds in which you are putting your money. With annuities, you must understand each of the contract provisions and how they work. Annuities are long term commitment. If you don’t understand exactly how the contract works, you risk getting unintended results many years down the road. Take the time to read all material, positive and negative, that you can find. Then ask every question you can think of when talking to the insurance agent. In doing this, you will quickly narrow your focus to the most important points of concern to you.
Once you make a decision, you will be secure in the fact that you know what you will be getting in the future.
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