How Are Annuities Affected by Interest Rates?
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, you are looking for the highest interest rate you can earn on your premium.
When interest rates are higher, deferred annuities grow more and immediate annuity payments are higher. Although interest rates aren’t the only consideration for insurers setting annuity rates, they are a key factor.
If you are interested in purchasing an annuity, but are contemplating whether to buy now or wait for interest rates to rise, revisit your holistic financial plan. Perhaps, an annuity is sensible for you, but it may not make sense to put all your money into one. Rather, an annuity could be a nice complement to a portfolio of stocks, bonds, alternative investments and cash equivalents.
— Thomas Brock, CFA®, CPA
What Is Considered a Good Interest Rate for an Annuity?
There is no universally good or bad rate for an annuity. Rather than thinking about whether the return itself is good or bad, it’s better to rephrase the question slightly.
Instead, ask yourself if purchasing the annuity would make you better off. That’s a broader and more purposeful question. Remember, because annuities are insurance products designed to provide guaranteed lifetime income as opposed to growth, it’s somewhat counterintuitive to think of these products in terms of “good” interest rates.
For example, maybe you are considering using 10% of your savings to purchase a single premium immediate annuity (SPIA). That decision involves considering the tradeoff between the income and stability the annuity would provide and the income you could have otherwise generated with the money. Often, that other option is a diversified portfolio of stocks and bonds.
You should compare the possibility that you may spend more from the diversified portfolio with the fact that the annuity income is secure. If you decide the annuity is a good choice, then that implicitly means the interest rate is sufficient.
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How Delaying Your Purchase Can Lead To Financial Loss
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 value of the foregone growth on those funds. And if the funds had the potential for exponential growth and income tax deferral, the financial loss may be greater than you think.
Future Uncertainty
Perhaps the most glaring issue is that you can’t know that interest rates will actually rise in the future.
The Federal Reserve’s monetary policy largely influences interest rates as they seek to stabilize the economy. We can’t predict either the economy or the Fed’s reaction to it. Interest rates may rise, fall or even remain flat for very long periods of time.
Lost Time
If you own a deferred annuity, waiting to buy means you’re missing out on potential growth.
“Deferred” refers to the fact that payments begin in the future, rather than immediately after you purchase the annuity. During that time, your annuity may grow according to the terms of your particular contract. Your interest will likely compound, although some annuities do pay simple interest.
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 terms of an annuity, this would be your premium — in the first year. 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.
If you wait, you miss out on the time your annuity could have been accumulating that compound interest.
If you wait to purchase your annuity, you’ll need to be sure that whatever you decide to do with that money in the meantime is expected to grow at a faster rate than the annuity would have. Otherwise, you aren’t actually better off.
Keep in mind that annuities also have the benefit of growing tax-deferred. You don’t have to pay tax on it until you begin receiving your payments.
Real-World Example: What You Could Lose by Waiting
Several factors influence the potential loss you could incur by waiting for interest rates to increase. The most significant of these factors include the type of annuity you buy and the interest crediting method the insurer uses to determine how interest is handled.
Imagine you’re interested in a multi-year guaranteed annuity (MYGA) purchased with a lump-sum premium of $100,000 that guarantees a 2.4% interest rate for five years and would grow in value to $112,589.99 by maturity.
If you wait a year to buy this type of annuity, you would need to secure a 3% interest rate to accumulate the same value by your target date.
This example won’t apply to every type of annuity. 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.
To illustrate, imagine depositing that same $100,000 into a high-yield savings account that offers 1.0% for one year. You would have an additional $1,000 after the year is up. If you then put the entire $101,000 into a four-year MYGA, you would need a lower 2.75% interest rate to accumulate $112,576.75 by your target date.
Lock In Fixed Annuity Rates as High as 6.9%
Other Strategies To Consider
Before you decide whether to wait to buy an annuity, consider additional strategies:
Annuity Laddering
Rather than using the entire amount you intend to on one annuity contract, you can purchase several annuities at different times to follow an annuity laddering strategy.
That may mean using a portion of your savings to purchase a SPIA in each of the next five years rather than all at once. Or, you may purchase several MYGAs, each with different maturity dates. For example, you may purchase MYGAs that mature in each of the next five years. If rates do rise your most recent purchases will benefit.
1035 Exchange
You also have the option of using a 1035 exchange to transfer to a new annuity contract with a better interest rate later. If you’re using this strategy, consult a trusted financial advisor to ensure compliance.
Stick To Your Plan
Thinking in terms of return maximization on your annuity is not likely to be the best framework for making your decision in the first place. Your original plan may be the best option for your circumstances.
Remember that the main benefit of annuities is their ability to provide you with a secure and reliable income stream. Whether an annuity is a good idea for you or not is more about the pros and cons of owning an annuity and how it fits into your overall plan rather than the return you might receive.
Guarantee financial freedom with an annuity.