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.

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.

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. Because annuities are not offered by banks, naturally they are not FDIC insured.

   

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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.


Contact your financial professional for more information about this subject and to seek guidance on what type of policy fits your specific needs.

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