What happens to annuities if interest rates increase?
Traditional fixed and indexed annuities are both sensitive to fluctuations in interest rates, therefore they typically become more valuable as rates increase.
With a fixed annuity, the insurance company will invest the premium you pay. The company seeks to earn an interest rate above what it credits to the annuity’s account value. For example, the company may determine it can earn 5 percent annually on its investment portfolio. So it may credit the annuity 3 percent annually and keep the remaining 2 percent to keep its business profitable and operating. Therefore if insurance companies are able to earn a higher rate of return on their investments, they can credit more to the annuity contracts held by their customers.
To better ensure they can meet those guarantees, insurance companies invest mostly in high-quality bonds, such as highly rated corporate bonds and government bonds. Companies also have a fair amount of assets invested in mortgage loans, with smaller portions allocated to cash and other short-term investments, real estate and equities.
Because of the high quality of insurance companies’ investments, they will cost more than other instruments. But insurers can also count on annuity owners holding onto those contracts for a longer period, therefore they can purchase bonds and mortgages with longer maturities. The long-term nature of these investments allows insurance companies to provide a higher crediting rate to annuities over time than many short-term investments.
Much of what insurance companies invest in are interest-rate sensitive vehicles. Therefore, if the overall rate environment moves up or down, the rates credited to annuities will typically do the same. One of the criticisms of fixed annuities is that they earn very little during extended periods of low interest rates.
Interest rates’ effect on indexed annuities
Interest rates also impact the cap rate on some indexed annuities. A cap is a ceiling on interest rate growth. A typical cap might be 8 percent. That means your annuity’s account value can not increase more than 8 percent in any one period, regardless of how much the benchmark index increases. If the index increases 5 percent, your account value will increase 5 percent. If the index climbs 12 percent, the account value will be limited to 8 percent.
The higher interest rates are, the more the insurer is earning on its investments and the higher the cap rate it can afford to set on its indexed annuity products. Indexed annuities also establish caps for an initial period, then reset those caps at a renewal period based on portfolio performance and prevailing interest rates. Many insurers also have contractual minimum cap rates that state that caps can be no lower than a certain percentage regardless of the interest rate environment.
The bottom line is that if rates increase significantly, insurance companies will earn more on their investments. A rising rate environment usually increases competition among insurers as they have additional resources to increase crediting rates and add features. Consumer typically benefit from this competition.
Will rising interest rates affect the annuity I already own?
When you purchase a fixed deferred annuity, the insurance company guarantees a rate of interest for a set period. The initial guarantee period may be a year or could be five or even 10 years.
Once that initial guarantee period expires and if the owner is still deferring income until a later date, the insurer will reset the interest rate that is credited to the contract.
The new rate, called a renewal rate, will somewhat depend on the performance of the insurer’s investment portfolio. If the yield on the portion of the portfolio that funded the original investment has dropped considerably because of lower rates, the company will likely lower the renewal rate. After all, the yield on the assets backing the annuity has dropped. This can happen even though short-term rates may have increased. In this situation, advisers may recommend cashing out the original annuity, provided it’s beyond its surrender period, and buying a new annuity at a higher crediting rate.
Oftentimes, an annuity’s renewal rate will correspond with the prevailing interest rate at the time of renewal. That means if interest rates have risen since the time you purchased the annuity, your contract will begin earning a higher rate of interest upon renewal. The same holds true if interest rates have declined since purchase.