Interest Rate Floors

What Is an Interest Rate Floor?

An interest rate floor is simply a minimum interest rate that is credited to an annuity’s underlying investment portfolio. Regardless of the market and the performance of the insurance company’s own investments, it must honor the minimum interest rate stated in the contract.

Variable annuities do not have the protection of interest rate floors, but they also don’t have limits on gains.

An interest rate floor is a fundamental feature of fixed annuities and most fixed index annuities. Also referred to as a guaranteed rate of interest, it is a risk-mitigating feature that appeals to highly risk-averse investors that do not wish to subject themselves to the possibility of loss of principal. 

Thomas J. Brock, CFA®, CPAInvestment, Corporate Finance and Accounting Professional

Thomas Brock, CFA®, CPA, is a financial professional with over 20 years of experience in investments, corporate finance and accounting. He currently oversees the investment operation for a $4 billion super-regional insurance carrier.

Interest Rate Floors and Annuity Types

To understand how interest rate floors work, you first need to know a bit about the various types of annuities and how interest is credited to each.

Interest Crediting by Annuity Type

Fixed Annuities 

The insurance company sets a declared rate that is credited for a guaranteed term, after which a renewal rate is set. The guaranteed term is typically one year for traditional fixed annuities. Multi-year guaranteed annuities pay a fixed rate for a longer period, such as three to 10 years.

Fixed Index

Interest is credited based on the performance of a stock market index. Most fixed index annuities also offer the option of allocating a portion of the premium to a bucket of fixed investments. In such cases, the annuity uses an indexed strategy and a fixed strategy. The funds allocated to the fixed bucket earn interest in the same way traditional fixed annuities earn interest.

Variable

Unless it allows you to allocate a portion of your premium to a fixed account, a variable annuity will have no minimum guaranteed interest rate. It will, however, have unlimited upside potential because interest is credited based on the performance of the selected investments.

According to the U.S. Securities and Exchange Commission, “the money in the [variable] account will vary according to the amount of premiums you pay, the amount of contract fees and expenses and the performance of the investment options you choose.”

In addition to these basic interest crediting methods, specific pricing levers make it possible for insurance companies to provide their clients with annuity income benefits. One of these levers is the interest rate floor.

What Are Typical Interest Rate Floors?

According to Wink Intel, fixed and multi-year guaranteed annuities (MYGAs) generally offer a minimum guaranteed floor of 1% or more, while fixed index annuities usually offer a guaranteed floor of no less than 0.00%.

This floor protects the annuity owner from the negative effects of declining interest rates. Therefore, fixed annuities are considered a safer option than variable annuities. Fixed index annuities, which are also subject to caps, spreads and participation rates, are considered moderate-risk products. The average interest rate floor for a fixed index annuity ranges from 1% to 3% on at least 87.5% of the premium paid.