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The Truth About Buying Annuities: Fixed Rates

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People equate a fixed rate with a safe and secure investment. But fixed has a different meaning to the insurance companies issuing the fixed rate annuity than it may to you.
This chapter is from the book

This chapter is from the book

  • “An investment in knowledge always pays the best interest.”
  • Benjamin Franklin

If your dog or cat could talk, they probably would tell you that they are not too thrilled about being “fixed.” But when it comes to a guaranteed fixed rate on their annuities, owners are pretty happy with the security of knowing that the rate of return they will be receiving from their annuity is fixed. People equate a fixed rate with a safe and secure investment. But fixed has a different meaning to the insurance companies issuing the fixed rate annuity than it may to you.

Insurance companies go by their version of the Golden Rule, which is that since they have the gold, they get to make the rules. And, according to their rules, the fixed interest rate that they promise to pay you on your annuity is not necessarily fixed for the full term of your annuity, but rather only for whatever period they decide they will guarantee a specific fixed rate.

Buried within the fine print of your fixed rate annuity may be a provision stating that the guaranteed fixed rate you are credited with in your annuity is guaranteed only for as little as a year; if you shop around, however, you can find companies that will guarantee their interest rate for as long as ten years. The actual interest rate you receive after the guarantee period is determined by the insurance company. Although there is indeed a minimum guaranteed rate, that rate is low—generally around 3%. For example, although the rate that attracted you to the particular annuity is guaranteed for only one year, you are left with a surrender period that will penalize you if you decide to leave the annuity for a better-paying investment at the end of that first year.

Generally, as with Certificates of Deposit, the longer the length of the duration of the annuity, the higher the interest rate that the insurance company will commit to. In fact, you may find a close correlation between the guaranteed rates in a fixed rate annuity and the rates for a bank-issued Certificate of Deposit for a similar period.

I don’t know the investment track record of Nostradamus, but when you are trying to determine whether you are better served by a long- or short-term annuity, a key factor is whether you think interest rates will rise or fall in the upcoming years. If you think interest rates will be rising, you will want to commit to the shortest period possible so that at the end of your annuity, you can get a new annuity with a new, higher interest rate. On the other hand, if you think that interest rates are likely to go down, you will want to get an annuity with the longest period of a guaranteed interest rate.

Time to bail

An important provision in a fixed rate annuity is the Bail Out provision. This term, which is found within the fine print of your annuity contract, permits you to get out of your annuity without any penalty if, after the initial guaranteed interest rate period, the insurance company renews your annuity at an interest rate that is lower than the original rate by at least an amount designated within your annuity contract, which may be 1%. For example, if you had an initial guaranteed interest rate of 5% and, at the end of your guarantee period, the insurance company offered a new guaranteed rate of 4%, you would have a specific period of time after receiving notice of the proposed renewal rate to decide whether to either accept the new guaranteed rate or take your money out of the annuity without having to pay any surrender fees. It is important to remember, however, that if you do withdraw your money from an annuity to invest in something other than an annuity, you will be subject to a substantial federal income tax penalty if you are under the age of 59½. On the other hand, it should be noted that if you decide not to bail out and instead accept the new guaranteed interest rate, a new surrender charge period also begins.

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