Understanding a market value adjustment on deferred annuities
Purchasing an annuity provides the ability of investors to shift many types of risk onto the issuing insurance company. If you buy a fixed or indexed annuity, the insurance company takes on the risk of investment. If you opt for lifetime income from your annuity, the insurer also bears longevity risk, meaning you no longer have to worry about making your money last for your entire lifetime.
Traditionally, insurance companies that issued annuities also bore the risk of how interest rate movements might affect the investment. But some insurance companies have shifted interest rate risk to annuity owners through a feature called a Market Value Adjustment (MVA).
Why MVAs are necessary for insurance companies
An MVA is a featured included on some deferred annuities, which are contracts made with an insurance company. With a deferred annuity, you make a single purchase payment or a series of payments to the company. In exchange, the company promises to make regular payments to you or a payee you specify, starting at a specified date for a designated period.
To fund that future income, insurance companies invest your purchase premiums in low-risk securities such as government bonds. When you make a withdrawal, the insurer must sell part of its investment to free up your cash.
This is why the insurance company issuing the deferred annuity will require you to leave most or all of the money in the annuity for at least a set period before you can take withdrawals, typically from 3 to 15 years. Otherwise, you will have to pay a surrender penalty, which is a percentage of the amount withdrawn. Many annuities, however, offer a free withdrawal percentage, which allows you to take out a percentage of the annuity’s value without a charge. A typical free withdrawal amount is 10 percent of the account value.
How the MVA works
Typically, an MVA will only come into play if you make a withdrawal before the surrender period that exceeds the free withdrawal amount. If this occurs and the annuity has an MVA feature, your annuity’s account value is adjusted downward if interest rates have risen since you bought the annuity, and upward if rates have declined.
This is because if interest rates increased from the date of purchase to the date of withdrawal, the insurance company has to sell investments that are less valuable because they pay a lower interest rate than what is currently available on the market. Conversely, if prevailing rates have declined since you purchased the annuity, the insurer’s investments are more valuable because they pay a higher interest rate.
One way to think about an MVA is to compare it with an adjustable rate mortgage (ARM). With an ARM, you pay a fixed rate for several years, after which the mortgage rate adjusts to whatever the market rate is at the time of adjustment.
Some advisors suggest that in a falling rate environment, you can potentially profit by cashing in your fixed annuity with MVA contract before the term ends. Even with surrender fees, a substantial market value adjustment could enable you to make a healthy profit on your original investment.
At the same time, you would be surrendering an annuity paying a higher rate of interest than what would be available in a lower rate environment. Also, you would not have a vehicle for retirement income later unless you purchased another annuity or other income produce.
Insurance companies sometimes market MVA annuities as products that offer flexibility of different guarantee terms combined with higher interest yields.
Because you are taking on more risk, insurers typically offer a higher interest rate on MVA annuities than those without an MVA. But you will want to carefully consider whether the higher rate is worth the added risk.