Annuities can provide many benefits to investors who
are looking for guaranteed income that they cannot outlive. But some annuity
products are better than others, and the benefits that these products offer can
vary depending upon the prevailing economic conditions when they are created
and marketed. The Federal Reserve is likely to increase interest rates sometime
soon, but how will this affect the annuity market? Is it smart to wait for a
while after rates go up before purchasing a contract?
How Annuities are
Constructed. The guarantees that life insurance carriers make on their
products are backed by the income that they generate from their cash reserves.
These reserves are invested in well-diversified portfolios that hold stocks,
bonds and other instruments. And the terms of the products that the carrier
offers are dictated by the amount of income that is generated from the cash
reserves. When income levels are high, carriers can offer better terms on their
products, which usually come in the form of higher guaranteed initial bonuses
and interest rates. But when interest rates are low, then less income is
generated from the cash reserves and carriers are eventually forced to reduce
the terms on their offerings to their customers.
To some extent, the right answer as to whether you should buy an annuity will
depend upon the type of contract that you purchase. If you are going to buy a variable
annuity, then there is probably no reason for you to wait. This is because the
rate of return that you will get is dependent upon the performance of the
mutual fund subaccounts inside the contract. You will most likely have one or
two bond funds to choose from, and you can earn higher interest from those as
interest rates rise.
However, if your contract pays an initial premium bonus,
this amount may increase with interest rates. If that is a key factor for you,
then waiting until the Fed has raised rates a few times may be a wise choice.
However, stocks often underperform in rising rate environments, so it may not
be worth the wait if you intend to invest a significant portion of your
contract in stock subaccounts.
If you are investing in a fixed annuity, on the other
hand, then the rate and terms will be set when the contract is issued, and you
will not be able to get out of it without paying a surrender charge in the
first few years. For this reason, you may be better off waiting for the Fed to
raise rates before jumping in, because fixed annuity rates will rise with the
Fed Funds Rate.
Beware of Permanent
Choices. Many investors at this point are waiting to invest in annuities
because they are seeking a guaranteed stream of income from them. And while
that can be a smart choice for consumers, locking in a stream of income now
will have the same effect as buying a 30-year Treasury bond. Why buy a
long-term bond now, when rates are due to rise?
Those who are able to wait for perhaps two or three years
could then lock in a much higher rate at that time. The same goes for
annuities, because the payout from an immediate annuity, or any contract that
is annuitized will be based on current interest rates and economic conditions. It
may be wise to try and run some hypothetical scenarios to see how much a
contract might pay if interest climb by two points in the next three years
versus starting a payout now. Those who need to do this can start by finding
out what rates companies were paying when rates were last at that level and
then compare that to the current payout being offered.
There may be cases where starting a payout now and
reinvesting the proceeds appropriately may yield a better return over time than
waiting. It would be wise to enlist a financial advisor or other professional
for this type of exercise.
The Bottom Line. Predicting
the future movement of interest rates can be difficult at best and impossible
at times. But at this point, rates can only rise and are bound to do so at some
point in the not-too-distant future. Those who are looking to buy annuities can
either sit on the sidelines and wait, buy a portfolio of contracts with
laddering maturities or find a carrier that offers contracts with maturities of
three years. Those who are looking to lock in a guaranteed stream of income by
annuitizing their contracts should probably invest in an appropriate short-term
instrument that will mature after rates have risen.
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