Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable annuities pose much more risk than fixed annuities. Variable annuities are tied to market indexes, which recessions tend to pummel. Fixed annuities, by contrast, offer guaranteed rates of return. Though fixed annuities provide peace of mind during recessions, they tend to underperform, at least compared to their variable counterparts, when the economy is doing well. During good times, variable annuities reward investors willing to shoulder higher risk by providing, on average, more aggressive returns.

How Annuities Work

Annuities are niche investment products often used for retirement planning. Unlike most investment vehicles, annuities do not come from traditional wire houses or brokerage houses. They are uniquely managed by life insurance companies, and the person most likely to sell you an annuity is not a stockbroker but an insurance agent.

An annuity accumulates interest, which is tax-deferred, until you reach age 59.5. At this point, the annuity begins returning its balance to you, both principal and interest, through a series of fixed payments. Depending on how the annuity is set up, the payments might occur every month for five years, 10 years or for the remainder of your life.

Annuities are popular because they provide a sort of salary during retirement. Once you start taking distributions, you receive a regular check, always for the same amount.

Fixed Vs. Variable Annuities

The defining characteristic of a fixed annuity is that during its interest-accumulating phase, the rate of interest you earn is guaranteed. In this regard, a fixed annuity is more similar in nature to a certificate of deposit (CD) than it is to a stock or mutual fund.

Also because of this feature, fixed annuities are not classified as securities. Therefore, the SEC does not regulate them, and a person who sells them is not required to maintain a Series 7 or Series 63 license. Life insurance agents, most of whom are not licensed to sell securities, love to sell fixed annuities, in no small part because the commissions are huge.

A variable annuity is so named because its interest rate varies based on the investment tool to which it is tied. Most variable annuities are invested in mutual funds, which are bundles of stocks, bonds and money market instruments. Because these investment vehicles, in particular stocks, vacillate based on economic conditions, variable annuities expose you to risk during recessions.

During a variable annuity's accumulation phase, your balance hopefully will increase due to interest. However, when a recession hits, it is possible your balance will decline if the investment vehicle where it is parked contracts in value. While fixed annuities do not pose this risk, they also do not stand to grow your balance as much during good economic times.

Advisor Insight

Dan Stewart, CFA®
Revere Asset Management, Dallas, TX

How annuities perform in a recession depends on the type of annuity and its investment strategy. For instance, if you are invested in an equity-indexed annuity and the stock market tanks, you will likely earn only the guaranteed minimum interest with very little gains.

On the other hand, if you have a fee-only annuity, which is free of commissions and surrender penalties, you have a lot more options, such as moving the capital into investments that perform well in a recessionary environment, or using some of the money for short selling. As for the insurance backing the annuity, it is generally safe no matter the market backdrop, as the insurance industry is highly regulated and is required to hold a certain amount of reserves to meet liabilities.