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How Fixed Rate Annuities Earn Interest
Fixed annuities provide a
minimum guaranteed interest rate. If the insurance company believes they can pay extra interest from their general
account, above and beyond this minimum guarantee, they will declare a fixed rate
of interest and pay the annuity owner a stated interest rate for a period.
How Do They Pay Interest?
It might be easier if we compare how an annuity
pays interest with the way a bank pays interest.
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As you know, when you place your money with the
bank they invest this money, earn a return, and after subtracting
their costs pay you net interest rate for a stated period of time. Your principal does not fluctuate, but the interest you
receive can, and usually does, fluctuate from period to period. And
the fluctuation can be extreme – CD rates fell 69% from the fall
of 2000 to the fall of 2001. But in any case, this sums up how a CD
works.
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A fixed annuity operates the same way,
except you place your money with an insurance company instead of a
bank. When you place your money with the insurance company they
invest this money, earn a return, and after subtracting their costs
pay you net interest. |
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What do they invest
in?
A score of years ago you could say that banks earned their money by
making loans and insurance companies made their money by primarily
buying bonds, but only half of that is still true.
The bulk of insurance
company holdings are still bonds. They may own a smattering of
direct loans, possibly some preferred stocks and perhaps some real
estate, but by and large they buy bonds because of the
predictability of the income. The change is that due to the
securitization of debt - a topic I will not even try to go into -
many banks own few direct loans, but own lots of bonds, possibly
some preferred stocks and perhaps some real estate. |
One Year Or Multiple Year
Rates
All fixed annuities, often referred to as Flexible
or Single Premium Deferred Annuities guarantee the interest rate for at least the coming
policy year (or guarantee the rate of participation in the case of an
index annuity). Typically, a fixed annuity will guarantee the rate for one
year at a time and declare a new interest rate on the policy
anniversary for the next year. But the new rate can never be less than the
minimum guaranteed interest rate.
Other fixed annuities will lock-in initial
interest rates for two years, three years, and up to ten years. These are
referred to as Multiple Year Guaranty Annuities
(aka MYG, MYGA).
Some may refer to these as "CD style" annuities because like a
CD you can lock in a rate for years; however, these are not CDs, are not
issued by a bank, and are not FDIC insured.
Minimum Rate
A fixed annuity guarantees to credit a minimum yield and that is what
makes a fixed annuity a fixed annuity instead of an investment. The
minimum rate is almost always stated and locked in when the annuity policy
is issued. It is usually a specified rate –
nowadays ranging from 1.5% to 3.0% –
but it may be linked to movements of an external interest indicator –
like 5-year U.S. Treasury Notes.
How Do They Pay An Initial
Bonus?
Many annuities offer an upfront bonus increasing either the first-year
interest credited or adding to the premium on which interest crediting is
based. Regardless of the method, the bonus is essentially the early
payment of future interest.
If you looked at two identical annuities and
one credited a 5% initial interest bonus and the other did not, you would
find over time that the bonus annuity would credit less interest in future
years than the one without the bonus. After the cost of the 5% bonus is
recovered future rates on both annuities would be similar.
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