How Do Interest Rates Affect Different Annuity Types?
The Annuity Man
In a perceived low interest rate environment, I’m always being asked about interest rates and annuities. When I say “perceived low” interest rates, people need to understand that the United States 10 Year Note is still the highest 10 year equivalent rate in the world. In other words, we still have the highest interest rates. Sad but true, and the Jimmy Carter rates of the past will probably never happen again in most of our lifetimes. I think we might be in the "new normal" when it comes to interest rates.
It’s important to point out that there are many types of annuities available, and all of them have unique benefits and limitations. So when people ridiculously say "I hate all annuities," which type are they specifically referring to? If you have a brain and are rational, you can't hate them all! Let’s take a look at how interest rates affect specific annuity types:
SPIA (Single Premium Immediate Annuity): Your life expectancy at the time you start payments is the primary pricing mechanism. Interest rates play a secondary role. The only exception is if you bought a "Period Certain Only" SPIA, and then interest rates would bes the primary pricing factor. SPIAs are the original annuity design, dating back to the Roman Times, and most are purchased for the lifetime income guarantees.
DIA (Deferred Income Annuity): As with SPIAs, your life expecancy at the time you decide to start payments is the primary pricing mechanism. Interest rates play a secondary role. DIAs are the same structure type as a SPIA, but with different start date parameters.
QLAC (Qualified Longevity Annuity Contract): As with SPIAs & DIAs, your life expectancy drives the pricing train. Interest rates are the caboose of that train, and play a secondary role. QLACs are actually a DIA structure, but can only be used in Traditional IRAs and some 401k type retirement plans.
MYGA (Multi-Year Guarantee Annuity): Interest rates are the sole factor for MYGA pricing. MYGAs are the annuity industry's version of a CD (Certificate of Deposit). The difference is that in a non-IRA account (i.e. non-qualified), MYGA interest grows tax-deferred. With CDs in a non-IRA account, you would have to pay taxes on the interest earned every year.
FIA (Fixed Index Annuity): Interest rates do play a role in the cost of the index call options purchased by the carrier, in addition to the caps/spreads (i.e. limitations) placed on the potential index call option gains. Interest rates also play a role in the bonds held, and the declared fixed rate within most policies.
VA (Variable Annuity): Historically, low interest rates means higher stock market returns…so variable annuity separate accounts (i.e. mutual funds) should potentially perform better. Attached benefit riders can also be affected by interest rate levels.
Income Rider: Income Riders are attached benefits to a deferred annuity (typically used with a FIA or VA) that provide future income guarantees. Interest rates affect the % growth that Income Riders offer during the deferral years, but your life expectancy at the time you take the payments still is the primary pricing mechanism.
The bottom line is that you can’t time it, so don’t try. Annuity companies have the big buildings for a reason. They price their products so you can’t time it. For example, if you are waiting to buy a SPIA (Single Premium Immediate Annuity) until interest rates move higher…then you would have to factor in the payments missed while waiting…and how long it would take to break even from your “timing fiasco.” Get it? That's a tough factual pill to swallow for most investors used to looking for that sweet spot or arbitrage moment to buy. Those "buying signals" don't exist with annuities. It's important to remember that annuities, regardless of type, are contracts between you and the issuing life insurance company.
When you find the highest contractual guarantee that best fits your specific situation, then lock it in and transfer the risk to the annuity company. Make sure to shop all carriers, because annuities are commodity products.
Do we all want interest rates to go higher? Of course! But it’s important to understand how rates affect specific annuity types so you can make an informed/factual decision. As you now know, annuities are not all the same.