Here’s a true paradox about annuities and annuity rates; they’re simple and complicated.
“The basic annuity is easy to understand: With a single-premium immediate annuity, you hand over a lump sum to an insurance company and you’ll receive a set amount of guaranteed income for life, no matter how long you live,” states Kim Lankford for AARP. “The payouts are based primarily on your age, your gender and the interest rates when you buy the annuity.”
Income annuities “can be useful for prospective retirees who lack meaningful streams of retirement income, like Social Security and pension, or for those whose tolerance for market risk is low enough to make them fearful of what has historically been the optimal inflation hedge — stocks,” says Tim Maurer, a certified financial planner and director of adviser development for Buckingham Wealth Partners.
Annuities are not always simple. Many varieties are available, including variable, fixed, fixed index, immediate, and deferred. In addition to providing guaranteed lifetime income, income annuities help defer taxes and protect against stock market losses.
“For most people other than the sophisticated, knowledgeable investor, these other types of annuities may not be suitable for retirement income,” adds Lankford. “The rules, the fees, and the role they can play in your financial plan can be very different.”
But, because annuities are long-term commitments, you should also know as much about them to make sure they fit into your retirement plan. And, that includes the following 11 things you didn’t know about annuity rates.
1. Different annuity, different rate.
As annuities age, their value usually grows at a set rate each year. And, this is known as the annuity rate.
Generally, if you own a deferred fixed annuity or a multi-year guaranteed annuity (MYGA), you can easily predict the projected value of your annuities. Why? Because providers guarantee growth rates for a fixed period, in most cases between 3 and 10 years. However, annuity rates have a tendency to change daily, so you should check their rates the day before making your purchase.
Additionally, since many annuity providers invest in bonds, annuity rates are closely tied to bond yields. As such, annuity rates tend to increase in tandem with bond yields. In contrast to bonds, however, a fixed annuity is not affected by market fluctuations. That means you won’t face the same level of risk as a bond investment.
When it comes to income, variable, or fixed index annuities these rates are harder to forecast. The reason is these annuity types don’t come with a guaranteed fixed interest rate. As a consequence, you won’t find advertised rates for these types of annuities because their rates fluctuate according to market conditions.
2. Fixed annuity rates are set by insurance companies.
Typically, it’s up to the insurers who offer fixed annuities to decide how they set growth rates. And, don’t worry about getting swindled. The annuity contract details how the growth rates are established.
Depending on the contract, the company will usually offer a guaranteed minimum rate for a set period of time. Again, this is usually three to ten years.
At the same time, rates are set differently by different carriers. In general, however, the carrier lumps a consumer’s premium into the one that is collected on behalf of all customers. The reason is that the insurers buy bonds and use that guaranteed return to either provide rates to consumers or buy options to offer upside potential on an index, such as an FIA (fixed index annuity).
Fixed-indexed annuities (FIAs) combine a fixed strategy that guarantees a set rate for a set term with an indexed strategy utilizing at least one of the following pricing methods:
- Participation Rate. Using this percentage, the insurer calculates the amount of interest they will credit to an indexed annuity contract based on the change in an index during the period of the contract.
- Interest Rate Cap. You are limited to the growth that can be achieved in an indexed annuity by your annuity provider.
- Interest Rate Floor. The rate at which an annuity’s investment portfolio is credited.
- Rate Spread. To arrive at the amount of interest credited to a fixed indexed annuity, the insurance company subtracts a percentage from the change in the index during the contract term.
3. Annuity rates influence your payments.
“Annuity payouts are definitely tied to interest rates,” says David Blanchett, senior education fellow with the Alliance for Lifetime Income and head of retirement research Morningstar Investment Management. “So if interest rates rise, payouts are going to increase. The problem is we don’t know when, or if, this is going to happen.”
In other words, this is the impossible task of timing the market. “It is very difficult to predict when [interest rates] might rise,” says Eric Henderson, president of Nationwide Annuity. “If an annuity is the right solution for a client at the current time, it is probably unwise to gamble on rates going up.”
4. Annuity rate vs. rate of return.
A lot of people think that annuity rates (also known as annuity payout rates) are similar to the rates they get on a deposit account (for example, a CD) or retirement fund.
Due to the insurance nature of annuities, immediate annuity rates differ from traditional investment rates. A payout rate is calculated by taking the annual payout amount and dividing it by the original investment amount. To put it another way, the rate is the percent of the principal that you get back each year through payments.
Annuity payout rates are not the same as pure-interest returns on bank accounts or retirement fund returns.
For example, an insurance company website may mention the current rate of 5% for immediate annuities. You would receive $5,000 per year if you purchased an annuity for $100,000. However, with each annuity payment received, you gain part of your principal back.
As such, you should resist comparing immediate annuity rates with other investments on the basis of their rate of return. Although you can compare the current annuity rates of one annuity with another, calculating the internal rate of return (IRR), the annualized return of your investment, provides a much better indication of its investment potential.
5. The average interest rate and rate of return will vary.
The interest rates for annuities vary according to their type. Fixed annuities, for instance, provide guaranteed returns. Variable annuities, however, fluctuate with the performance of the investment portfolio connected to them.
It should also be noted that the risk of losing money is also higher for annuities with higher interest rates.
And, as with the average interest rate, the average rate of return also varies. Remember, a life annuity is structured so that the provider pays ongoing income to the annuitant for the remainder of his/her life. With that in mind, rates of return are determined by how much was spent on the annuity and how long after purchase, the annuitant lives.
6. You can compare annuity rates using the three buckets strategy.
Let’s be honest, it’s difficult to compare annuity rates. For starters, traditional fixed annuities guarantee an interest rate for a one-year period. But, at the same time, other fixed annuities guarantee rates for three to ten years. And, a multi-year guaranteed annuity (MYGA) is a contract for a multi-year term.
The earnings of variable annuities, in contrast, aren’t guaranteed. Why? Because they depend on an underlying stock portfolio. In addition, a fixed index annuity, uses crediting methods that are based on stock market performance.
The average consumer can find this confusing. To better understand annuities, we need to understand how they fall into specific categories.
- The method of earning interest on an annuity. The interest earned on fixed annuities, including multi-year guarantees, is guaranteed for a certain period of time. In terms of interest rates, these are the simplest types of annuities. As an example, Due offers a 3% on whatever you have deposited.
- The moment the premium becomes annuitized, i.e. when the lump sum becomes a payment plan. One of the benefits of immediate annuities is that they convert premiums into income immediately upon payment. But, there is no requirement that the annuitant start receiving income payments right away. A deferred income annuity (DIA) can be annuitized immediately, but payments start later.
- Amount of time between the purchase date and when income payments begin. This is different from the annuitization period, which is the second bucket used by annuity carriers to classify their products. There is no accumulation period associated with immediate annuities. An immediate annuity’s primary function is to provide a guaranteed income stream right away. Conversely, deferred annuities accrue interest in accordance with their contracts during the accumulation period.
7. Ads touting 7% guarantees are misleading
“Can you earn 7% on a fixed annuity, guaranteed?” asks Ken Nuss for Kiplinger. “Online ads often make this promise.”
“Unfortunately, those ads are misleading,” Nuss adds. “They’re not completely false, but they set unrealistic expectations.” And, as a result, people need to be talked back into reality.
“The truth is complex,” he continues. Certain annuities do guarantee 7% rates.
There is, however, a catch. The actual return on the annuity isn’t guaranteed. “Instead, it guarantees the growth of an income account value created by an optional rider,” explains Nuss. “It’s not money you can withdraw.”
In short, if “it sounds too good to be true,” then it is.
“Buying a lifetime income rider creates the income account value, which grows at a guaranteed annual rate of 4% to 7%.,” he says. “The income account value is used to calculate the amount of future guaranteed lifetime income payments.” This option is typically available with indexed annuities and usually comes with a 1% annual fee.
“That’s why some annuity marketers get away with claiming a misleading 7% return,” notes Nuss. “Those ads are usually placed by marketing firms that sell the leads to annuity agents.”
So, what can you realistically expect? The top rate for a five-year fixed-rate annuity, as of January 2022, is 3.15%, according to AnnuityAdvantage’s online rate database. For a 10-year annuity, it’s 3.25%, and for a three-year guarantee, it’s 2.50%.
8. Fixed annuities > CDs.
“Fixed annuities generally offer 35 percent higher rates than CD rates in all economic eras,” says Samuel Rad, an instructor at UCLA and a planner at Affluencer Financial in Los Angeles.
A MYGA is the annuity counterpart of CDs that also offers tax-deferred growth. In other words,, you don’t have to worry about paying taxes until you begin receiving payments.
Additionally, unlike CDs, traditional fixed annuities and MYGAs are not insured by the Federal Deposit Insurance Corporation (FDIC). The policyholders, however, are backed by the life insurance companies that issue the policy as well as by state guarantors.
9. Surrender rates can affect annuity rates.
There are usually fees associated with withdrawing some or all of the annuity’s cash value, known as withdrawal fees, or wiping out the policy’s entire value, known as surrender fees. The withdrawal or surrender charges apply if you withdraw or surrender during a set period of accumulation.
According to current interest rates, the withdrawal or surrender charges on some annuities can be adjusted according to market value adjustment (MVA). Therefore, if interest rates have changed since you purchased the policy, you may end up paying a higher or lower charge.
Each provider has its own terms for withdrawals and surrenders. In some cases, providers let policyholders make a certain number of free withdrawals over the course of the policy. Some companies may even reduce or waive charges if you have the annuity for a certain period of time.
Furthermore, annuities with highly restrictive withdrawal and surrender terms typically offer higher rates. Because of these restrictions, short-term investments in annuities are discouraged, thus decreasing insurer risk. As you consider the implications of withdrawal and surrender charges, it’s important to weigh flexibility against annuity rates.
10. It doesn’t pay to wait for interest rates to rise.
Even though many people are eager to maximize their return on investments, waiting to buy an annuity could be a costly mistake. That may sound like an over-exaggeration, but it’s true.
Investing in an annuity too late can cost you tax benefits and compound interest. And, yes, this is even true when the economic climate isn’t in the best of shape.
“But even in a lower interest rate environment, compounded growth and tax deferral can grow savings faster than clients may think,” explains John Williams, the Regional Sales Director, Individual Annuities at The Standard. “To illustrate, if someone puts $50,000 into a five-year guaranteed annuity paying 2.05%, that person would be guaranteed $55,339 at the end of five years, minus any withdrawals taken.”
“By waiting one year before buying an annuity, that $50,000 would have to earn 2.57% annually for four years to catch up with the older annuity’s value of $55,339,” Mr, Williams adds. “And by waiting two years before buying the annuity, that $50,000 would have to earn 3.44% annually for three years to achieve the guaranteed $55,339. Example calculations like these can help demonstrate to clients that while interest rates are a determining factor in growth, they should not be the only one.”
11. When an annuity reaches maturity, you can cash it or renew it.
“The renewal rate is the interest rate the insurance company sets at the end of an annuity’s contract term,” writes Kim Borwick for Annuity.org. “This rate can be lower than short-term interest rates, depending upon the performance of the funds in the insurer’s portfolio.”
An insurer will offer you a guaranteed interest rate based on the current interest rates, for example, if you purchase a fixed indexed annuity when interest rates are high. Considering annuities are long-term investments, any profits earned from the contract will be reinvested, adds Borwick. During the contract term, if rates fall, the insurance company will set a new, lower rate based on its current assets.
But, also be on the lookout for a bailout provision.
“A bailout provision is an annuity contract provision that allows the annuity owner to surrender the annuity contract if cap rates or renewal rates on a fixed annuity fall below a specified level,” Borwick clarifies.
“If economic conditions force the insurer to reduce your renewal rate to a level that triggers the bailout provision, you will have the option of surrendering your contract.”
