1 December 2024

Rising Rates and Annuities: What You Should Know

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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.  

Decisions, decisions. 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. 

Click here to access the full article on MSN Money.

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