Annuity costs fluctuate with interest rates, inflation and life expectancy. Higher interest rates often lead to lower costs, while inflation protection increases upfront costs. Understanding these factors helps buyers time their purchase and secure a guaranteed retirement income.
When planning for retirement, financial security should always be at the forefront of one’s mind. Annuities are often part of this conversation of financial security. But while the promise of lifetime income is reassuring, one aspect that often puzzles potential buyers is how the cost of annuities changes over time.
Whether you are considering purchasing an annuity today or weighing your options for the future, understanding the factors that influence the cost of annuities is crucial for making the right decision.
What Determines the Cost of an Annuity?
Before we explore how annuity prices change, it’s important to understand what determines the cost of an annuity in the first place.
When you purchase an income annuity, the insurance company takes your premium and converts it into guaranteed income based on several factors:
- The premium amount: The premium amount is the amount you’re investing in the annuity. Generally, the more you invest, the higher your guaranteed payout will be.
- Your age: Annuities are calculated based on life expectancy. The older you are when you purchase the annuity, the shorter the expected payout period, and thus, the higher the income you can receive for the same premium. This payout amount is usually influenced by the withdrawal rate offered in the annuity contract. These withdrawal rates are different each year depending on how old you are.
- Current interest rates: Interest rates significantly affect annuity prices as they determine how much income the insurance company can generate from your premium. Generally, the higher the interest rate environment, the higher the lifetime income.
- The type of annuity: Different annuities have different structures (e.g., fixed, variable and indexed) and payout options (e.g., immediate vs. deferred or life-only vs. joint-life). The more guarantees or flexibility you add, the more expensive the annuity.
- Additional features or riders: Optional add-ons like inflation protection, death benefits or long-term care riders can increase the cost of an annuity.
Now that we know what drives an annuity’s initial cost, let’s examine how these costs change over time.
How Interest Rates Influence Annuity Costs Over Time
One of the biggest factors affecting the cost of annuities is the interest rate environment. Insurance companies use interest rates to determine how much income they can generate from your premium over time. When interest rates are high, insurers can create more income, offering higher payouts for the same premium. Conversely, when interest rates are low, the payout is lower for the exact cost.
The Impact of Low-Interest Rates
Over the past decade, we’ve been in a historically low interest rate environment, pushing the cost of annuities higher. In a low-rate world, insurance companies cannot earn as much on their investments, offering lower payouts for each premium dollar invested. If you purchased an annuity during this period, you may have noticed that you had to pay more for the same level of guaranteed income compared to previous generations.
What Happens When Interest Rates Rise?
Recently, we’ve seen interest rates rise, and annuity payouts have increased. This is because insurers can now earn a higher return on the money you invest with them, allowing them to pass some of these benefits to you through higher payouts. If you plan to buy an annuity in the future, it’s worth keeping an eye on interest rates, as a higher interest rate environment could lower the relative cost of annuities.
When To Buy an Annuity for the Best Value
Given that the cost of annuities can fluctuate over time based on various factors, many retirees wonder when the best time to buy an annuity is.
While it’s impossible to time the market perfectly, there are a few strategies you can consider to optimize your purchase:
- Watch interest rates: If interest rates are low, consider delaying your purchase until rates rise. Higher interest rates generally mean better annuity payouts.
- Evaluate your health and life expectancy: If you’re in poor health, you may be able to lock in a higher payout with an impaired annuity. On the other hand, if you’re healthy and expect to live longer than average, you may want to buy sooner rather than later to avoid higher costs as you age.
- Consider inflation and economic conditions: In periods of high inflation, the cost of annuities with inflation protection may rise. Weigh the benefits of locking in a lower price today versus the potential for higher payments in the future.
- Consider an income rider early: Income riders can provide a lot of growth for an income payout if deferred for at least 5 to 10 years. When planning for retirement, annuities with income riders offer guaranteed growth of the income value benefit, which can be as high as 9% per year until activating income.
Inflation and Its Effect on Annuity Costs
Inflation is another key factor affecting the cost of annuities over time. It erodes the purchasing power of money, impacting both the price you pay for an annuity and the value of the income it provides over the long term.
How Inflation Impacts Annuity Prices
When inflation rises, the real value of guaranteed income from an annuity declines. This is why many people add inflation protection riders to their annuities, which increase payments each year to keep pace with inflation. However, adding this feature increases the upfront cost of the annuity.
In periods of high inflation, the cost of adding an inflation rider to your annuity can increase significantly because insurers know that they will need to adjust your payments upward more aggressively over time. In contrast, in a low-inflation environment, the cost of such riders may be more manageable.
Annuities Without Inflation Protection
For those who opt for an annuity without inflation protection, the initial cost may be lower, but the actual value of their income may decline as the years go on. For example, a fixed payout of $2,000 a month may seem like a comfortable income today, but 20 years from now, inflation could make that amount feel insufficient. Thus, while you might save money upfront, the long-term costs could come from lost purchasing power. One solution to this is to purchase multiple annuity contracts and plan on activating the income streams at different times – the longer you wait, the higher the payout for each contract.
How Longevity Affects Annuity Pricing
Longevity risk—the risk of outliving your savings—is one of the key reasons people buy annuities in the first place. However, your life expectancy also directly influences the cost of an annuity. The longer you are expected to live, the longer the insurance company expects to pay you, and the higher the annuity cost.
Rising Life Expectancy
Life expectancy has been steadily rising in most parts of the world, which directly impacts the cost of annuities. As people live longer, insurance companies are on the hook for more payments, and this risk is priced into the annuity cost. In practical terms, this means that the cost of annuities for younger individuals is higher than it would have been for someone of the same age in previous generations.
Health and Annuity Pricing
In addition to average life expectancy, your personal health can affect the cost of an annuity. Suppose you are in poor health or have a shorter-than-average life expectancy. In that case, you may be eligible for an impaired annuity, which provides a higher payout because the insurance company expects to pay you for a shorter period. Conversely, if you are in excellent health, the insurer may expect to make payments for longer, which could increase the cost. However, most annuity applications do not ask questions related to your health.
The Role of Market Demand and Competition
The cost of annuities is also influenced by market demand and insurer competition. When demand for annuities is high or when insurers are aggressively competing for market share, prices may be more favorable for buyers. Conversely, when demand is lower, or competition is less intense, the cost of annuities may rise as insurers adjust their pricing strategies.
For instance, in the wake of the 2008 financial crisis, many people flocked to the safety of guaranteed products like annuities, sometimes leading to more favorable pricing. However, as market conditions improved and demand shifted toward riskier assets, annuity prices rose again.
Navigating the Changing Costs of Annuities
Annuities can provide valuable peace of mind by guaranteeing income in retirement, but their cost is influenced by various factors that change over time. From interest rates and inflation to life expectancy and market demand, understanding these variables can help you make more informed decisions about when and how to buy an annuity.
By staying informed about these dynamics and working with a financial professional, you can find the right annuity at the right time and secure the income you need to enjoy a comfortable retirement.
Editor Norah Layne contributed to this article.