Demystifying Annuity Rates of Return: What You're Really Earning

When planning for retirement, annuities are a popular option for individuals seeking a reliable income stream. However, understanding annuity rates of return can be complex, as they vary significantly depending on the type of annuity and the terms of the contract.

Looking at the different types of annuities, how providers determine rates of return, and factors that impact these rates can help you assess what you're earning from an annuity.

Understanding annuities

Annuity insurance products can provide a steady income stream, typically during retirement. They are contracts between an individual and an insurance company, where you pay a lump sum or series of payments in exchange for regular disbursements starting at a future date. Annuities can reduce the risk of outliving your savings by offering predictable income.

Types of annuities

Several types of annuities offer different features and rates of return:

• Fixed annuities: These provide a guaranteed rate of return for a specified period. The insurer invests the premium in fixed-income securities with predetermined returns. Fixed annuities offer stability and predictability but may yield lower returns than other annuity types.
• Variable annuities: The rate of return for variable annuities reflects the performance of investment sub-accounts, similar to mutual funds. These annuities offer the potential for higher returns but come with more risk, as the value can fluctuate based on market performance.
• Indexed annuities: These annuities reflect, in part, the performance of a market index, such as the S&P 500. They offer a middle ground between fixed and variable annuities, with the potential for higher returns while still providing some level of protection against market downturns.
• Immediate annuities: Intermediate annuities can provide an immediate income stream, as payments begin soon after you pay the premium. These are ideal for retirees seeking immediate cash flow.
• Deferred annuities: With deferred annuities, payments begin at a future date, allowing for tax-deferred growth of your funds. These are suitable for people planning their future retirement income.

How providers determine annuity rates of return

Various factors can influence an annuity's rate of return, including the type of annuity, the terms of your contract, and external economic conditions.

Fixed annuities

The contract specifies the rate of return on a fixed annuity. The rate doesn't change during the interest rate term. The insurance company determines this rate based on factors such as prevailing interest rates, the company's investment portfolio, and the annuitant's age and life expectancy.

Guaranteed rate: Fixed annuities provide a guaranteed interest rate, which remains constant over the contract period. This rate is the minimum rate that can be credited to you annuity. Your provider sets this rate at the time of purchase.

Variable annuities

Variable annuity returns depend on the performance of investment sub-accounts. These sub-accounts can include stocks, bonds, and money market funds, which can vary based on market conditions. These annuities do not provide a guaranteed rate of return.

Investment performance: The performance of an annuity's underlying investments can influence the rate of return. Variable annuities offer the potential for higher returns but also present market risk.

Indexed annuities

Indexed annuity returns link to the performance of a market index. The provider credits interest based on index gains, subject to participation rates, caps, and spreads.

Participation rate: The participation rate is the percentage of an annuity's credited index gains. For example, if the index gains 10% and the participation rate is 80%, this credits the annuity with an 8% gain.

Cap rate: The cap rate is the maximum interest rate the annuity can gain, regardless of how well the index performs. If the cap rate is 6% and the index gains 10%, the annuity gain is 6%.

Spread: Spread is a percentage your provider subtracts from index gains before crediting the annuity. If the index gains 10% and the spread is 2%, the annuity earns an 8% gain.

Immediate and deferred income annuities

For immediate and deferred annuities, the terms of the contract and the timing of payments govern your rate of return.

Immediate annuities: The rate of return for intermediate annuities depends on the amount of your premium, the payout schedule, and your life expectancy.

Deferred income annuities: The rate of return for intermediate annuities depends on the amount of your premium, the time period until income payments begin, the payout schedule, and your life expectancy.

Factors affecting annuity rates of return

Several factors can impact rates of return, affecting an annuity's overall earnings. Understanding these can help you make informed decisions when selecting an annuity.

Interest rates

Interest rates play a significant role in determining rates of return, particularly for fixed annuities. Higher interest rates generally yield higher returns, as your provider can invest premiums in higher-yielding securities, whereas low interest rates may result in lower returns.

Current economic environment: Interest rates fluctuate based on economic conditions, including inflation, monetary policy, and market demand. Providers can adjust annuity rates accordingly.

Market performance

Market performance is a primary factor in determining returns for variable and indexed annuities. Strong market performance can lead to higher returns, while downturns can result in losses.

Investment choices: The selection of assets influences the performance of a variable annuity's sub-accounts. Diversification can help mitigate risk and enhance returns.

Index performance: The performance of the underlying index impacts indexed annuities. Understanding the index's historical performance and volatility can give insight into your annuity's potential returns.

Fees and charges

Annuities often come with various fees that can affect their overall rate of return. These can include administrative fees, management fees, mortality and expense charges, and surrender charges.

Administrative fees: These fees cover the costs of managing the annuity and are typically a fixed percentage of the account value.

Management fees: If you have a variable annuity, these fees are for managing the annuity sub-accounts and can vary based on the chosen funds.

M&E charges: If you have a variable annuity, thesefees compensate the insurer for the risk of providing guaranteed payments and are typically a percentage of the account value.

Surrender charges: These fees apply if you withdraw or cancel the annuity before a specified period. Surrender charges can reduce the overall return if you access funds early.

Annuitant's age and life expectancy

If you decide to annuitize your contract and take guaranteed income payments, your age influence the rate of return assumed in determining those income payments. Insurers use actuarial tables to calculate payouts based on these factors.

Younger annuitants will receive lower payments due to a longer expected payout period, while older annuitants receive higher payments.

Assessing annuity rates of return

Understanding annuity rates of return means evaluating your annuity's potential earnings and comparing them to other investment options. Here are some steps to help you assess the performance of an annuity.

1. Calculate the effective rate of return

To determine the effective rate of return on an annuity, consider the guaranteed and potential earnings, along with any fees and charges. For variable and indexed annuities, this involves assessing their historical performance and/or projecting future returns. Note that past performance is not a guarantee of future returns.

Net return: Subtract any fees and charges from the gross return to calculate the net return. This figure provides a more accurate picture of earnings.

Annualized return: Calculate the annualized return by considering the compound growth over time. This step helps you compare an annuity's performance to other investments.

2. Compare with other investments

Compare the annuity's rate of return with other investment options, such as stocks, bonds, and mutual funds. Consider the risk, volatility, and liquidity of each option to determine the best fit for your financial goals.

Risk tolerance: Evaluate your risk tolerance and investment objectives. Annuities can offer stability and guaranteed income, while other investments may provide higher returns but come with more risk.

Diversification: Consider diversifying your portfolio to balance risk and return. Annuities can complement other investments, providing a reliable income stream while allowing for growth potential.

3. Evaluate payout options

Annuities offer various payout options, including lifetime income, specified payment periods, and joint-and-survivor payouts. Each option assumes a different rate of return, so evaluate your needs based on your financial goals.

Lifetime income: Lifetime income provides payments for life, ensuring income security. The rate of return depends on life expectancy and payout terms.

Period certain: A period certain annuity offers payments for a predetermined period, regardless of your life expectancy. This option may provide higher payments but comes with the risk of outliving the income.

Joint-and-survivor: This option provides income for the annuitant and a designated beneficiary. A joint-and-survivor annuity may result in lower payments but offers financial protection for your loved ones.

4. Consider inflation protection

Inflation can erode the purchasing power of fixed annuity payments over time. Consider annuities with inflation protection features, such as cost-of-living adjustments or indexed payouts, to preserve the value of your income.

COLAs: Some annuities offer COLAs, which adjust payments based on inflation rates. This feature helps maintain your annuity's purchasing power but may come with higher costs.

Indexed payouts: Indexed annuities provide returns that align with a market index, offering some protection against inflation. Evaluate the participation and cap rates to understand potential earnings.

A closer look at annuity rates of return

Demystifying annuity rates of return is crucial to making informed decisions about retirement planning. Understanding the different types of annuities, how providers determine rates of return, and the factors that impact these rates can help you assess your income from an annuity. Comparing annuity returns with other investment options and evaluating payout options and inflation protection can help you determine the best fit for your financial goals.

MM202710-310305