In principle, annuities sound like the perfect financial vehicle — or at least the perfect financial vehicle for people who don’t trust themselves to stick to a budget. Regularly spaced payments for life: What’s not to like about that? Indeed, many people are tempted by the structured settlements offered by insurers, lottery holding companies and others. That the annuity payment recipients are forgoing the chance to grow their money by taking those payments in lieu of a single payment illustrates the general conservative nature of humans. (For more, see:  Watch Your Back in the Annuity Game.)

Why take a lump-sum payment (and risk losing it) when you can find a payer willing to remove the risk for you? We do more to avoid pain than to seek pleasure, and that trait is capitalized on by the insurance companies that sell annuities. But once you’ve set yourself up to receive annuity payments, are you really that safe? Or does Murphy’s Law apply here, too? (For more, see: Is an Annuity a Perpetuity?)

Not Without (Some) Risk

Annuities are supposed to provide their recipients (or to use the arcane legal term, “annuitants”) with peace of mind. No matter how profligate you might be, it’s impossible to squander your entire fortune when you know a check will be arriving at the beginning of the next month and every month thereafter. 

Every investment carries uncertainty, however. Even municipal bonds run the risk of the issuing municipality going bankrupt. It doesn’t happen often, but it can. The value of Treasury inflation-protected securities — another favorite among investors who hate insecurity — is contingent on the indefinite continuation of the U.S. government. Washington, D.C., already had its domestic authority challenged pretty severely in the 1860s, and who’s to say we aren’t due for another such rupture? (For more, see: What is the Safest Investment?)

As a practical matter, annuities are vulnerable only to the extent that their issuers are. Most annuities are paid out by insurers or similar companies, and most annuities are variable. Variable annuities are de facto investment vehicles, usually invested in equities, and in that respect similar to mutual funds in that they incur the same risks as mutual funds. Is a variable annuity akin to a 401(k) plan? Yes, except for the tax treatment, which is a huge difference that makes variable annuities non-starters for most people. Plus, if the annuity holder dies, his or her spouse will be stuck with a big capital gains tax bill. (For more, see: The Cost of Variable Annuity Guarantees.)

Fixed annuities, on the other hand, aren’t invested in equities. This means fixed annuities are not directly exposed to market swings, but it's important to note that they are not completely immune to economic conditions. What they are exposed to is inflation. For example, there are guaranteed future income annuities on offer that are issued at age 55, but if deferred for five years will guarantee a 6.6% annual payout. If that were offered in 1980 when inflation was in the double-digits, investors would have lost real dollars. Now that was a long time ago, but a lot can happen in the years between buying a retirement investment vehicles and actually needing the money. (For related reading, see: The Great Inflation of the 1970s.)

Another risk is related to deferred annuities, which allow the investor to schedule payments but only make sense if you plan to stop working in a predetermined year — and actually do so. Much like with 401(k) plans, there’s a penalty for withdrawing early; the choice for some becomes paying a penalty to withdraw early or trying to hang on until the early withdrawal phase passes. Annuities often have all of the drawbacks and only some of the advantages of standard retirement plans. (For more, see: Deciphering Deferred Annuity Designations.)

And finally, if the insurance company that issued your annuity goes bust. there is no guarantee you'll get any of your money. Some state insurance commissions will bail investors out up to a certain amount, such as $100,000 or $500,000; other states don't do anything at all. (For more, see: What If Your Insurance Company Goes Belly-Up?)

The Bottom Line

Life annuities — and to a lesser extent, term certain annuities (which last only for a fixed period) — are a morbid over/under wager made with the issuer on how long you’re going to live. Beat the actuarial life tables, and you’ll come out ahead (although you’re going to die anyway). Leave this realm early, and the issuer profits off you. The important thing to remember isn’t so much that annuities can lose money – again, any investment can – but that your options are often so much better. IRAs and 401(k)s offer advantages that annuities typically can’t match, with only a negligible increase in risk, if any. (For related reading, see: Are Annuities for Seniors Only?)

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.