“How can my insurance company guarantee my interest rate on an annuity when they can’t predict the market? After all, the whole reason I’m going with a fixed annuity is because I can’t predict the market!” That was a question posed to me from a client who was thinking about purchasing a fixed annuity with the purpose of moving a portion of his retirement assets from a higher-risk investment to a financial vehicle with less risk exposure. Mainly, what he wanted was to understand how insurance companies are able to set a pre-determined interest rate and even go as far as to guarantee it. One way insurance companies make these guarantees is through the bond market and the interest rates that the Federal Reserve sets on their government bond offerings.
How the Economy Can Affect Annuities
The Federal Reserve started out this year optimistically enough by raising interest rates and the price of bonds for the first time since 2006. Then, international markets began to struggle, and economic growth wasn’t quite as high as initially expected. Since then, the number of anticipated interest rate increases by the Federal Reserve has dwindled, with many financial institutions predicting there will probably only be one more interest rate hike for the year.
This matters to annuity holders because of how annuity premiums are invested. Insurance companies pool the funds they receive from contract holders and invest them in conservative investments such as bonds. The rates they can earn on these bonds and bond funds affect how they set the annual interest rates on annuities.
Understanding the Value of Bonds
When an insurance company accepts a premium payment from you for an annuity, it usually puts that money into a general fund. Regulations require the insurance company to hold sufficient funds in reserves to pay out the benefits on their contracts. Any surplus over this amount is open to being invested by the insurance company, which is necessary to grow the fund to continue making payments to their customers in the future.
Because the interest credited to fixed annuities is conservative, it makes sense that these insurance companies will look for lower-risk investments to grow these funds. What many insurers will do is take a portion of these funds and use them to purchase government bonds or bond funds on the primary market.
When the insurance company purchases the bond, it gets that bond at the current interest rate set by the Federal Reserve. When the Federal Reserve raises the interest rates, that decreases the appeal of any bonds issued before that interest rate increase. Many say that interest rates and bonds have an inversely proportionate relationship because, generally when interest rates rise, bond value goes down because demand for those bonds goes down.
So, when an insurance company is not anticipating any increases or only small increases in the Federal Reserve’s interest rate, this allows it to estimate the potential future return of those investments with relative accuracy which, in turn, allows it to set its own interest rates.
The Balancing Act of Paying and Earning on Fixed Annuities
Insurance companies must earn money on their general fund to manage ongoing payments to annuitants. They use interest rates, the bond market, and other means to determine how much these underlying investments have the potential to earn. This requires a balancing act, because if they overestimate earnings, they must still pay out those promised interest rates. This is because individual annuities themselves are not investments. They’re fixed insurance contracts and the insurance company is contractually obligated to credit the interest and make the payments it promised. If the insurance company overestimates how well its investments will perform, it will need to contribute more to pay for the guarantees, resulting in a potential loss to the company.
At the same time, the insurance company wants to ensure its fund is profitable enough to offer attractive interest rates to consumers. While an insurance company might, for example, be able to predict 1% growth on their underlying bond fund investment, offering annuity holders a 1% interest rate isn’t going to pull many potential customers. So insurance companies must balance competitive interest crediting for potential customers with its growth potential on the funds in the future.
With fewer raises in interest rates currently, it’s easier for insurance companies to make this assessment of interest rates and guarantee that they will at least be able to pay out the minimum interest rate promised in the contract. The minimum interest rate is, of course, the guaranteed fixed rate initially outlined in an annuity contract. The guarantees outlined in the contract are backed by the financial strength and claims-paying ability of the issuing company.
Using the Federal Reserve’s predictions on economic growth, as well as the performance of the bond market, is much of what gives insurance companies the ability to estimate how their underlying investments may perform and offer annuitants a fixed, guaranteed interest rate. However, your annuity’s guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company – which means the guarantee is only as good as the individual insurance company that backs it. This is why it’s important to discuss any potential annuity purchase with a financial professional. For more information on how insurance companies are able to guarantee interest rates on fixed annuities, contact one of the insurance professionals in Retirement HQ’s network, or take a look at our annuity resource page.
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