Annuities are tied to interest rate policy – likely more than you think. Learn how these changes influence fixed and variable annuities, and discover strategies to adapt your investment approach. Stay informed and make the best decisions for your financial future with insights from industry experts.
Key Takeaways
- In the last few years, annuity holders have become accustomed to low Federal Reserve interest rates, with contracts clinched at rates as low as 0.25% to 0.50%.
- With the Federal Reserve’s benchmark interest rates now ranging from 4.75% to 5.00%, certain annuities may be significantly affected.
- Annuity holders should work with a financial advisor to adjust annuity strategies as needed when rates shift.
In September, the Federal Reserve made a substantial move, slashing its benchmark federal funds rate from 0.50% to a new range of 4.75% to 5.00%. The Fed’s Open Market Committee is set to meet again in December, with experts anticipating another rate cut by year’s end.
“With inflation data behaving and its 2% target in sight, the Federal Reserve will continue a rate reduction cycle, having begun with a supersize one-half of 1% drop in September,” says Mark Hamrick, senior economist at Bankrate. “More modest moves of one-quarter of 1% appear to be in the offing at the November and December meetings. Its focus has widened to include job market cooling, mindful of the dual mandate of stable prices and maximum employment.”
Annuity Holders Should Pay Close Attention to Fed Rate Policy
A big downward shift in interest rates significantly impacts annuities, some more than others. That impact could hit your annuities in ways you didn’t expect.
In the aftermath of the big September Federal Reserve rate cuts and in advance of likely further cuts, let’s take a closer look at how rate cuts impact annuities overall and in the current rate landscape.
The Connection Between Annuities and Interest Rates
Annuities tie their returns to interest rates by design, although those ties are stronger with some annuities and less with others.
“The impact of rate cuts on annuities depends on the type of annuity,” says Justin Haywood
president and co-founder of Haywood Wealth Management in Houston, TX. “For fixed annuities and multi-year guaranteed annuities (MYGAs), payout rates will likely be lower since they are tied to bond yields. As the Fed cuts rates, the yields on bonds and other fixed-income investments drop, which reduces the interest that insurers can offer on new annuities.”
For example, fixed annuities tend to deliver higher returns to stay even—or a step ahead—of current market returns. Since the Federal Reserve began boosting interest rates in 2020 to help keep the US economy competitive during COVID-19, buying a fixed annuity has been attractive, given rising rates of return linked to interest rates.
The formula used by annuity providers is also crucial when assessing an interest rate shift.
“Insurance companies invest the premiums they receive from consumers into assets that back the products they purchased,” says Tom Buckingham, chief growth officer at Nassau Financial Group in Hartford, Connecticut. “On fixed annuity products, insurers credit an interest rate to policyholders and retain a spread to cover expenses, taxes and profit margins. Consequently, if interest rates rise, consumers should expect higher credited rates on new deposits and vice versa.”
Simultaneously, the insurance industry has been getting creative with fixed annuities to attract more customers. Fixed index annuities, for example, are starting to offer higher return ceilings to land more buyers in what is still a high interest rate environment.
In contrast, variable interest annuities aren’t as impacted by interest rates and Federal Reserve rate policies.
“Variable annuities are less likely to be affected because they are tied to market performance rather than fixed interest rates,” says Christopher McGlynn, a certified financial planner and wealth management consultant at COMPACOM.
Scenarios Where Rates Impact Annuities
For annuity owners wondering about any interest rate moves right now, consider some likely impactors – these issues should be at the top of that list.
Rate cuts, which affect short-term interest rates, will likely result in lower credited rates on short-duration fixed annuities, such as 2-year and 3-year products.
“However, rate cuts likely will not significantly impact longer duration annuities, such as 7-year and 10-year fixed and fixed indexed annuities, because insurance companies invest a majority of the assets that back those products in longer duration assets,” Buckingham notes. “The yields on those assets are driven by the yield on longer duration US Treasuries, and the 10-year actually has risen over the past two months.”
The current and future rate cuts will also directly correlate with lowered fixed annuity interest rates.
“Annuities will follow suit, and owners looking to take out an annuity in the near future will see substantially lower interest rate returns compared to those who take one out now and who took one out within the last two years,” says Evan Patzer, retirement specialist at LifeWealth Solutions in Columbus, Ohio.
Understanding Surrender Periods and Future Rate Cuts
If you already have an annuity contract with high fixed account rates, in most cases, your annuity will not be affected by future rate cuts. “That’s the case until your annuity reaches the end of its surrender period,” Patzer notes.
Patzer’s advice for those annuity investors who remain worried about future rate cuts and want good, safe returns is to get on board now. “If you wait, rates will be too low on all safe investments, including CDs, money markets, high-yield savings and annuities,” he adds.
Leveraging Upfront Bonuses
Increasingly, insurance companies are tacking on up-front bonuses based on your initial annuity deposit amount.
These bonuses typically range from 10% to 12%. If you purchased an annuity five years ago when rates were low, it may be worth considering a switch. By exiting that annuity and paying any associated penalties, the deposit bonus could offset those costs, allowing you to invest in a new annuity with higher rates.
Are Rate Changes a Concern for Annuity Holders?
In short, consumers shouldn’t be too concerned about Fed rate cuts and their annuity investments.
“However, they should be mindful because lower interest rates can reduce annuity payouts,” McGlynn says. “Investors should consider the broader financial strategy and diversification and consult with a trusted financial advisor.”
Editor Norah Layne contributed to this article.
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