Fixed Annuity Interest Crediting Methods

Fixed annuities credit interest at a guaranteed rate, at least for the first period of the contract. The interest rate a fixed annuity earns can vary from 1% to as high as 5% or 6%, depending on the contract terms and prevailing interest rate environments.

Despite the fixed nature of the interest, insurers employ different methods for crediting it to the annuity contracts. The most popular methods of fixed annuity interest crediting are the new money method, the portfolio method and the tiered method.

Key Facts About Fixed Annuity Interest Crediting Methods

• Fixed annuities offer an unchanging and guaranteed interest rate, but the crediting methods used may vary.
• The new money method credits different interest rates based on the timing and manner of premium investments.
• The portfolio method credits the same initial interest rate and the same renewal rate to all annuity contracts regardless of premium timing.
• The tiered interest rate method either assigns rates based on the annuity’s premium value or adjusts the rate retroactively if the contract isn’t annuitized.

What Is the New Money Method of Interest Crediting?

The new money method, also known as the pocket of money method, is most commonly used for flexible premium fixed annuities. This method bases the interest rate on when the insurer receives each premium payment.

Using the new money method, insurers allocate premium dollars to the same investments while interest rates remain stable. If rates drop, the insurer begins allocating any new money received into different investments in a separate account. This applies not only to new annuity customers but also to flexible premium annuities that make a series of premium payments over time.

Timing takes on an important role in new money interest crediting. Because investment allocations change with fluctuations in the interest rate environment, a premium payment received at one time might get a higher or lower rate than a payment received in another period.

Collecting premiums in different “pockets” throughout the year makes the new money method more difficult and expensive for insurers to administer fixed annuities; still, insurers might use this method to attract annuity customers in bull markets when equity prices are rising.

Part of choosing the right annuity requires understanding how you plan to fund the contract now and in the future. While you cannot perfectly predict the future, you should choose a contract that will offer you the best chance of maximizing your contributions. For instance, if you never plan to annuitize your annuity, you should make sure the contract will not disadvantage your rate of return because of this.

Stephen Kates, CFP®Principal Financial Analyst for Annuity.org

Stephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.

What Is the Portfolio Method of Interest Crediting?

The portfolio method refers to how insurers using this method combine all the premium money invested in fixed annuities into one large investment portfolio. Because they invest all the money inside the same portfolio, all fixed annuity contracts will earn the same interest rate for the same period of time.

This method of interest crediting differs from the new money method because the insurer only offers one interest rate for the whole contract and for all their contracts, regardless of when they receive the premiums. The calculation of annuity renewal rates also varies between the two methods.

When the portfolio of investments matures, the insurer typically offers the same renewal rate to all annuity owners. This again differs from the new money method, in which an insurer may offer different rates to different pools of money both during the initial issuing of contracts and the renewal period.

What Are the Tiered Interest Rate Methods?

Some insurers use a tiered interest rate method for crediting fixed annuity contracts. Like the new money method, a tiered interest rate method means that one annuity might be offered a different rate than another and that the money inside a single annuity may not all earn the same interest rate.

There are two types of tiered interest rate methods for fixed annuities. The first type credits interest in tiers based on how much the purchaser invests in the annuity. For example, an insurer using this method might offer a 4% interest rate on the first $50,000 of an annuity, 4.2% for the next $50,000, 4.4% for the next $50,000, and so on.

The second type of tiered interest rate crediting method applies to what some may refer to as a “two-tiered annuity”. Under this crediting method, insurers provide a certain interest rate if the contract is annuitized, but retroactively lower the rate if it is not.

Two-tiered annuities were once a popular tax-sheltered annuity choice for teachers and school administrators in retirement funds. However, they are now banned in some states because of concerns about their marketing practices. These annuities have been scrutinized for potentially misleading consumers, particularly regarding the conditions under which different interest rates apply.

As you can see, while fixed annuities are simpler than other types of annuities, they can be complex in terms of interest crediting.

If you’re unsure about which crediting method would be best for your needs, consider working with a financial advisor who can walk you through all the nuances of a fixed annuity contract.

Editor Christy Bieber contributed to this article.