The Cost of Waiting for Interest Rates to Rise

When you have an investment that allows for compound growth, interest is added to your principal. If your interest is compounded annually, for example, the first year, you will earn interest on your initial investment — in the case of an annuity, this would be your premium paid. In year two, your interest will be calculated on the balance at the end of year one, and so on for the duration of the contract.

It’s important to note, though, that the potential for loss extends beyond the future value of your contract. The age at which you buy your annuity and your life expectancy will ultimately affect your rate of return and the legacy you leave to your beneficiaries.

Just as you would compare offers from lenders when purchasing a home, you should shop around and compare quotes from insurance companies when buying an annuity. The difference, of course, is that rather than seeking the lowest rate, as you would as a borrower who is obligated to pay interest, you are looking for the highest interest rate you can earn on your premium.

If it helps, you can think of your annuity premium as a loan to the insurance company. The insurance company is “borrowing” your money to invest in mutual funds or other securities and paying you interest on the loan.

Annuities are also heavily influenced by the 10-year Treasury yield — again, similar to mortgage rates. The 10-year Treasury bond is a government debt with a 10-year maturity. Backed by the U.S. government and considered a safe investment, these bonds are reliable indicators of investor confidence, and thus, the benchmark by which insurance companies set annuity rates.

Although the Fed’s rates aren’t the only consideration for insurers setting annuity rates, they are a key factor for insurance companies across the country.

The implication of rising or falling interest rates for consumers is the value of their annuity contracts.

Needless to say, the higher the interest rate on any financial instrument that offers a return the better. However, because annuities are insurance products designed to provide guaranteed lifetime income and tax benefits as opposed to short-term growth investments, it’s somewhat counterintuitive to think of these products in terms of “good” interest rates.

The benefit of an annuity to the contract owner is the regular income stream it generates, so annuities are often priced in terms of the monthly income they generate. And because the value of an annuity is ultimately tied to your life expectancy, you’ll want to broaden your criteria for a “good” annuity quote.

Tax benefits and compound interest are lost when you wait to purchase an annuity. The current economic conditions are unstable, and analysts are unsure of the ramifications for interest rates over the next several years. But the opportunity cost of holding on to your money remains.

Opportunity cost refers to the value lost when you choose an alternate course of action. In other words, when you delay purchasing an annuity — or investing your money in some other way — you lose the future value of those funds. And if the funds had potential for exponential growth and income tax deferral, the financial loss may be greater than you think.

Several factors influence the potential loss you could incur by waiting for interest rates to increase. The most significant of these factors are the type of annuity you buy and the interest-crediting method the insurer uses to determine how interest is handled.

For example, a multi-year guaranteed annuity (MYGA), which is a type of fixed annuity, purchased with a lump-sum premium of $100,000 that guarantees a 2.4 percent interest rate for five years would grow in value to $112,589.99 by year five.

If you wait a year to buy this type of annuity, you would need a 3 percent interest rate to accumulate the same value by your target date.

This example won’t apply to every type of annuity, and you have other options, including putting your money in a high-yield savings account for a year and purchasing an annuity with a higher premium.

For example, if you put that $100,000 in a high-yield savings account that offers 0.1 percent for one year, you would have an additional $1,000. If you then turned around and put the entire $101,000 into a five-year MYGA, you would need a 2.75 percent interest rate to accumulate $112,576.75 by your target date.

But the real loss you may face by waiting for annuity rates to increase involves the risk of outliving your savings and the opportunity to provide for your spouse and beneficiaries through the death benefits.

For example, if you purchase a single-life annuity early enough to fund the annuity with retirement savings before they are depleted, you’re ensuring income for yourself and your family regardless of how long you live.

For many retirees, this guaranteed income can mean the difference between receiving quality long-term care and going without assisted-living services. It can have a significant impact on quality of life after retirement and on the burden to spouses and children.

Depending on the type of annuity and your age and life expectancy, waiting for annuity rates to go up could cost you income and security, but before you make a decision about when to buy an annuity, consider strategies, such as annuity laddering, to minimize loss or types of annuities, including MYGAs, that don’t lock you into a particular interest rate permanently.

You also have the option of using a 1035 exchange to transfer to a new annuity contract with a better interest rate later.