Problems With Guaranteed Annuity Rates

by Ciaran John

Many deferred annuity contracts include some form of a rate guarantee. On a fixed annuity, the insurer may offer you one fixed rate for the entire duration of the annuity or offer you variable rates with minimum rate guarantees. However, you have to read your annuity contract carefully because rate guarantees sometimes include clauses that enable the insurer to pay a reduced rate. Furthermore, guaranteed rates leave you vulnerable to inflation risk.

Guaranteed Renewal Rate

Some insurance companies offer fixed annuity contracts on which you receive a guaranteed rate for the first year, or first few years, of the annuity term. When that rate expires, the insurer changes the rate to one that reflects the going interest rate at that time. In rising rate environments, expect your annuity rate to rise. If rates fall, your insurer must pay you a rate no lower than the guaranteed renewal rate in your contract. In many instances, guaranteed renewal rates are much lower than the initial rate of interest. If you buy such an annuity, you assure yourself of short-term gains, but a low renewal rate could mean a low average yield over the term of the contract.

Bailout

Insurance companies make predictions about future rate movements before inserting rate guarantees into contracts. However, the economy sometimes takes unexpected turns and if rates unexpectedly plummet, an insurance firm may actually lose money if it honors rate guarantees. Therefore, many insurers include bail-out clauses in contracts. With a bailout provision, the annuity contract states that if the insurer fails to offer you a rate equal to, or in excess of, the guaranteed renewal rate, you can withdraw your money without incurring a penalty. The bailout provision lets the insurer off the hook but leaves you with having to scramble to find a better investment option.

Variable Annuities

When you buy a deferred variable annuity, the insurance company usually invests your money into mutual funds. Your returns depend on the performance of those funds, but many contracts include guaranteed minimum income benefits that assure you of a certain amount of growth regardless of the market conditions. However, if you decide to cash in your annuity at the end of the term, you get the actual market value of the annuity and not the value that the GMIB rider entitles you to. You only benefit from the GMIB rider if you convert your annuity into an income stream and receive your annuity in the form of regular payments over the course of your lifetime.

Inflation

Some investors like annuities because the rates paid on these products often match or exceed the rates available on other fixed rate products such as certificates of deposits. While fixed annuities provide you with steady income over lengthy periods, the rate guarantees do not protect you from inflation. When inflation impacts an economy, prices start to rise, but the interest on your fixed rate annuity remains the same. This means that you lose spending power because you have the same amount of money to spend but everything suddenly costs more to buy.

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