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.
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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. 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.
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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.
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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.
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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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