This is one topic I should have addressed a long time ago. Insurance companies retain the right to make changes to rates inside an index annuity contract and lots of people take that to mean they are getting the raw end of the deal. It seems to show evidence of less control for the consumer and plenty of people avoid buying an annuity because of it.
Last week, during an annual review with a client, I got the question directly from a man who purchased an annuity from me two years ago. The second anniversary just passed so he is entering the third contract year. He mentioned that a friend of his in banking told him he should be concerned about the insurance company’s ability to make rate changes during the surrender period. It was the absolute best time to get the question since we were both looking at proof to the contrary. After two renewals this person still has the same rates and opportunity that he had when he got the contract.
After years of doing this I can tell you that there’s nothing to be afraid of. It doesn’t mean the rates will never change but it does show that there’s more to it than the whim of an insurance company. Cap and participation rates are based on two variables. Your money is invested in a pool of bonds and the interest earnings give the company money to buy an option on a market index. So interest rates and options pricing determine the rates that gives you potential for growth with an index annuity.
If interest rates or the cost of the option change from year to year, you’re more likely to see adjustments to the rates. Since option prices change constantly then you should expect some variability in the rates over time and it’s quite likely for them to increase as well, so long as the right conditions are met.
Over time there are several things that can change the rates and everyone needs to understand why it’s not such a bad deal and how it’s really no different than just about every other investment. A basic example using simple math is the best way I can illustrate this.
Let’s say you have $100,000 in an index annuity. The company bought bonds that provided interest to buy market options. After a couple of years with decent growth your account value is up to $110,000 so the company had to buy another $10,000 worth of bonds to back the contract and produce interest earnings. Do you suppose that interest rates and option pricing was a little different each time new bonds were purchased? New bonds mixed with old bonds will create blended yield that is different from the single rate when the contract was purchased. If interest rates have dropped then you might see a reduction in your cap and participation rates. If rates rise then it goes the other way.
Rate adjustments in an index annuity are no different than buying your own bonds or dividend paying stocks. New money gets new rates with a bond and that blends the yield higher or lower than the starting rate. It’s the same with stocks where purchase price determines the value of dividends relative to a return on investment. If a stock price doubles the dividend will effectively be half what is was before. There are several more variables that contribute to pricing and yield for stocks and bonds but the principle is the same. People only complain about it when it relates to an annuity.
There are other ways each insurance company operates to mitigate this risk from the outset. Obviously we all know that on the first day, the bonds backing an annuity haven’t earned any interest yet but you still get an option purchase for the first year. It’s an actuarial calculation that spans the term of the annuity and beyond. Many companies have done a really good job of keeping things steady in the long run. But every company needs the ability to make adjustments if there are dramatic changes in the economic environment. It takes a much deeper level of understanding to be able to truly appreciate what Guaranteed money means.
If this isn’t enough for you then there’s one last thing I can offer. There are literally a couple of contracts that offer cap and participation rates that are guaranteed not to change during the surrender period. It’s a feature that has been around for a few years but there’s one problem. These guaranteed rates are typically a fair bit lower than top rates on the adjustable side. A few years ago I passed up the locked rates and sold the adjustable rate because of more potential. As of today my past contracts are still higher than those with rates that are guaranteed not to change. Only time will tell if that holds up in the future. I have a feeling it will depend on interest rates.
With the stock market high and bond yields really low, I think the insurance products are a pretty good bet right now. Just don’t forget why you’re in this. It’s all about protecting money and there is no better way than with an annuity. Add a nice yield to it and it makes all the sense in the world.