Why Buy an Annuity When Interest Rates Rise?
The Republican takeover of the White House has stirred speculation that inflation will rise, largely based on positive consumer sentiment, steady growth in jobs and President Trump’s support for increased spending on national infrastructure projects. This is expected to lead to a gradual increase in interest rates by the Federal Reserve. In turn, higher interest rates lead to higher yields on government bonds and annuity payouts.
An annuity is an insurance contract that offers an option for guaranteed income for life. A fixed annuity provides a stable interest rate while the income payout for a variable annuity will fluctuate based on the market performance of the contract’s underlying subaccounts.
Annuity income payouts are based on three factors: current interest rates, the owner’s life expectancy at the time the contract is purchased and mortality credits. Mortality credits basically spread out the income that would have gone to annuity owners who died prematurely to other annuity owners in the insurance pool. Each of these factors impact the annuity owner in different ways.
- Mortality Credits – Mortality credits are created when people die sooner than expected and don’t receive as many income payments as they would have if they had lived their full life expectancy. That money goes into a pool that will then pay lifetime income to those people who live longer than their life expectancy. The younger you purchase an annuity, the more mortality credits you’ll likely earn because more annuity owners are likely to die during the longer timespan you own the contract.
- Age – the older you are when you buy, the higher your payouts, but the shorter the rest of your life. This means you’ll receive higher annuity payments for fewer years.
- Interest Rate – The higher the interest rates at time of purchase, the higher your income payouts for life.
These factors influence when people buy annuities. For example, should an investor buy an annuity now that rates have finally risen, or hold off on the chance that rates will rise even higher? Another interesting snag for insurers is that there is some evidence that life expectancy rates are actually slowing, so the question is whether they will factor in fewer years for payouts and thus increase income levels for new contracts.
Investors tend to compare the cost and benefit of buying bonds versus those of an annuity. Both instruments vary payouts based on interest rates, but both lock in those payout amounts based on the prevailing rate at the time of purchase. However, bonds eventually mature, leaving the investor with the option to reinvest and the quandary of how much income he’ll receive at that point based on current rates. An annuity, on the other hand, features regular, guaranteed cash payments for life regardless of the direction of interest rates. Therefore, if you’re fortunate enough to purchase an annuity when rates are high, you may be pleased with the payout and not have to worry about interest rates anymore.
Mix It Up
Creating a retirement income portfolio doesn’t need to be an either/or proposition. First of all, you can “ladder” annuities. This means invest a small amount at a time. If you invest in a fixed annuity now, you’re guaranteed to receive a certain level of income. If rates rise in a year, you could purchase another annuity for a higher payout, and so on. Assuming rates continue to rise, the ultimate payout would be substantially more than if you use all of your allotted assets to buy one annuity now. If you’re planning to convert, say, $150,000 of your nest egg into lifetime income, you might put $50,000 into three separate annuities over the course of several years rather than committing the entire sum all at once.
The same strategy can be used for bond laddering, which would diversify your nest egg even further.
High Price of Security
Annuities cost more than bonds and other types of investments due to the insurance guarantee. In fact, insurers are required to include in their pricing the cost of paying out income based on published life expectancy rates, overhead administrative costs plus a surplus amount to ensure the ability to remain solvent against potentially longer lifespans of annuity owners. This is a good thing, because the last thing an annuity owner wants is for his insurer to go out of business before he gets all of the income payouts he is due.
The key to deciding whether you should buy an annuity is based on how much guaranteed income you need in retirement. This means developing a household budget and factoring in Social Security benefits and any other retirement income sources. While prevailing interest rates do have an impact on the level of income an investor receives, it’s only a cursory concern relative to determining your overall income needs.