A classic mistake made when considering annuities is to focus too much on current interest rates and the direction they seem likely to move.
Annuities are income vehicles, so it’s natural to consider interest rates and the outlook for future rates. But too often the relationship between some annuities and interest rates is misunderstood, and that leads to less-than-optimum decisions.
There are many types of annuities, but I’m talking about those that protect your principal and provide safe, guaranteed income.
For those looking for guaranteed lifetime income, there are single premium immediate annuities (SPIAs) and deferred income annuities (DIAs).
SPIAs pay a fixed amount of monthly income beginning within the next 12 months, and the income is guaranteed to last for as long as you live. DIAs provide fixed monthly income for as long as you live, beginning at a time you select that is two years or more in the future. (There are variations in these annuities, but these are the basic features.)
Multi-year guaranteed annuities (MYGAs) are another type to consider. In a MYGA, you deposit money with an insurer. The insurer guarantees your principal is safe and adds interest to your account.
The interest rate might be guaranteed for only the next year, or it might be guaranteed for a longer period, depending on the annuity you purchase.
MYGAs with terms longer than one year generally pay higher yields than comparable bank CDs. Plus, taxes on the interest are deferred as long as the interest remains in the account.
Since about 2000, I’ve heard people say they’ll consider purchasing a SPIA or DIA when interest rates are higher. The statement assumes interest rates are the primary factor determining SPIA and DIA payouts.
Your life expectancy is the insurer’s main concern when deciding how much income to guarantee. The insurer estimates how long it is likely to have to pay income to you.
Interest rates are a secondary factor. In addition, the insurer is concerned about the long term when assessing interest rates and investment returns. Near-term changes in interest rates, especially short-term rates, aren’t the insurer’s major concern. Instead, the insurer estimates the investment return over the next 10 years or longer.
Another factor to consider when considering a delay in the purchase of a SPIA or DIA is how you’d invest the money while waiting to buy the annuity.
If you’ve earmarked money for guaranteed lifetime income but don’t plan to buy a SPIA or DIA for a few years, you probably will invest that money very conservatively. You don’t want to put the principal at risk in stocks or other risky investments. If you do, it’s possible you’ll have less money to put in the annuity and will receive a lower lifetime income.
You’re likely to protect the principal by investing in a money market fund or similar conservative vehicle and will receive a low yield in return. The insurer, on the other hand, will invest for the long term. It will assume the money you deposit it with it will earn a higher return than the safe investment you would buy. That higher return will be one factor in determining the lifetime income paid to you.
The result, even if interest rates rise in the next few years, is you’d probably receive a higher lifetime income by buying the SPIA or DIA now than you would receive by waiting a few years to buy the annuity.
Another factor to consider is what the insurers call mortality credits.
An insurer sells SPIAs and DIAs to a large number of people at a time. It estimates the average life expectancy of that group and uses that estimate to determine the lifetime income each will be paid.
About half the group will die before reaching average life expectancy. The insurer uses that knowledge to determine how much income it will guarantee to each member of the group.
In other words, the deposits of the people who don’t live to average life expectancy allow the insurer guarantee higher income payments to the entire group and pay more lifetime income to those who live to at least life expectancy. That’s known as mortality credits.
Also, though average life expectancy in the U.S. decreased the last few years, that’s unlikely to continue. It’s especially not likely to continue for those who don’t succumb to Covid-19 or haven’t developed substance abuse problems. Average life expectancy is likely to increase in the future, and insurers are likely to factor that into their calculations, reducing the guaranteed income.
That means if you buy a SPIA or DIA in a few years, you’re likely to receive lower mortality credits than if you buy today. It’s not a major factor, but it’s something to consider.
With MYGAs, the yield on your account does change with market interest rates. But you probably can’t time interest rate changes. If you could, you should be trading interest rate futures or options contracts.
A MYGA is acquired to lock in a guaranteed yield while protecting your principal. If you are worried that you might lock in a yield for several years today only to see interest rates rise higher in six to 12 months, then don’t put all your money in one MYGA.
Instead, create a MYGA ladder. Spread your money among MYGA contracts with different terms. Put one-third in a one-year MYGA, one-third in a three-year MYGA, and one-third in a five-yar MYGA, as one example.
When the one-year MYGA matures, roll it over to a three-year or five-year MYGA. With the ladder, you capture today’s relatively high yields and upgrade to higher yields if interest rates increase.
The important point is interest rate forecasts shouldn’t be a significant factor in annuity-buying decisions. You buy an annuity to create guaranteed lifetime income or to protect your principal while earning a guaranteed interest rate or both. If you want to time interest rates, consider trading options, futures, or long-term bonds.
Interest rates changed dramatically in 2022. By some measures, they rose faster in 2022 than any year in the previous 40.
How did that affect annuity payouts?
SPIA payouts increased 11% for men over the course of the year and 13% for women, according to Insurance NewsNet. Payouts on DIAs increased on average by about 42%, showing the importance of mortality credits and letting the insurer invest your money for a few years.
Here are more details and a longer-term perspective of how annuity payout rates have changed.