Understanding Annuity Rates
Annuities offer a variety of benefits to individuals gearing up for or in retirement, not the least of which is a guaranteed income stream that one cannot outlive. That income stream, and in some cases, the account value of an annuity are based on the underlying rate provided by the issuing insurance company. To understand how annuity rates are calculated starts with recognizing the three major components that come into play: the investment performance of the annuity company, the broad interest rate environment at the time of purchase, and the term of the annuity.
Let’s take a closer look at each aspect of an annuity rate calculation.
Annuity Rates Explained
Company Investment Performance – the companies issuing annuity contracts are able to pay fixed interest rates on deposit, and therefore guarantee income in the future, because they have the ability to generate a return on funds used to purchase annuities. Deposits from annuity purchases are often invested in a diversified portfolio. The investment mix of annuity company portfolios may include high-yield bonds, preferred stock, and other institutional-level investments that provide a relatively stable return over time. The stronger this performance, the more competitive the rate offered to new annuity contracts.
Broad Interest Rates – while annuity companies take some risk with their investment portfolios, they also take a close look at the current interest rate environment when issuing annuity rates. The movement of long and short-term interest rates has an impact on the performance of the company’s portfolio, especially if a significant amount of annuity deposits are invested in the bond market. If annuity issuers aren’t correct in their assumptions about interest rate movements, up or down, this could create a lower return on their portfolio. This results in a lower interest rate offered on annuity contracts moving forward. The opposite is also true; when performance is strong, interest rates offered on annuity deposits are higher.
Annuity Terms – the amount of time a deposit is held in an annuity influences the annuity rate as well. The longer the term, the higher the interest rate offered, and vice versa. This is because annuity companies have a longer period to invest the annuity deposit in their own portfolio. For annuities that pay a guaranteed stream of income, time also plays a role. An immediate annuity offers a lower rate because income is starting shortly after the funds are deposited. A deferred annuity often pays a higher rate, as income begins a year or more in the future.
There is a fourth component of annuity rate calculation – the deposit amount. Some annuity companies offer a higher annuity rate for more substantial deposits, while others provide the same annuity rate regardless of the amount used to fund an annuity. It is important to know that while this isn’t always a factor, it can play a role in calculating your annuity rate.
Having a basic understanding of the factors that influence how annuity rates are calculated is an essential step in selecting the best-fit annuity for you and your financial needs.