What are all these "Rate" in Annuity?

Author: Andrew Lee
About 3 minutes read.

DISCLAIMER

There are different type of rates that are mentioned and used in an Annuity Contract, and we would like to understand what does it mean. In addition to the meaning itself and how it works, note that, how the rate works sometime is tied to conditions (e.g. no withdraw, longer holding period, first-year premium, etc.) in the contract. When you look at a rate, make sure you understand what triggers that rate and how the rate is being applied. Consult with a qualified life agent or financial advisor if you have questions on how the rate works before signing any Annuity contract! Do not sign things you do not understand.

Here are some terminologies explanation to get started.

Market Value Adjustment - the increase or reduction of value due to interest rate fluctuation overtime. Simply put, the concept applies the present value (PV) and the anticipated rate of return to reflect the purchase price of an investment. Here is a simplified example, a 10-year face value $100 bond with 5% coupon rate could generate $5 per year and sold for $100 at the beginning. If the bond owner wants to sell it later and the current market rate is 10%, it is unlikely an investor will pay $100 for $5 return when the opportunity cost is $10 with the 10% rate somewhere else. In this case, the bond owner will likely sell the bond with a lower premium than the $100 face value such as $70. However, if the market interest rate is 1% which is lower than 5%, likely the investor will pay more than $100 such as $137. This usually applies to early withdrawal or within the surrender period.

Annual interest rate - the annual interest rate.

Current rate - This is NOT the guarantee rate. This interest rate is what the insurance company credits you for the year (aka annual interest rate), or month-to-month, etc. and declared by the board of directors.

Multi-Year interest rate - applying a guaranteed interest rate for multiple years instead of one year. This appeals to investors that may chose Certificate Deposit. Usually applies to early surrender of the annuity or on premature distribution tax penalty.

Teaser Rate (aka First Year Bonus) - Insurance company credits a higher interest rate than the current rate on the first year or a specified time period. This enhance the marketing effect to attract new investors. However, limitations may apply and must be disclosed to customers such as no withdrawal for the first X years. After the higher credited interest rate, the current rate could drop lower to cover the cost from the insurer. You do want to review the renewal interest-crediting rate history of the insurer as oppose to no bonus annuities.

Now, you understand some definition on interest rate from the insurance company/insurer, the following will talk about how the rate is derived. Here, we will use Indexed Annuity as an example. The concept of "Indexed" is very similar to Indexed Universal Life Insurance (IUL) which you can read more here.

Unadjusted Rate and the Crediting Factors 

In an Indexed Annuity, the annuity contract cash values are guaranteed as to principal and are also guaranteed a modest level of interest specified in the annuity contract. This Indexed Annuity product may participate in some of the growth of the market but shielded from its decline. There are different crediting strategies, and we will discuss the most easiest one to understand which is the point-to-point. The purpose here is not to explain these crediting strategies (we'll leave that to another post), but once we derive the rate from the strategy, how does the following factors apply.

Simply put, an annual point-to-point compares 2 dates, e.g. from S&P 500,

2019 Feb 6th  2,731.61

2020 Feb 6th  3,345.78

The derive unadjusted rate is (3,345.78 - 2,731.61) / 2,731.61 = 22.48%.

Spreads - this is what will be deducted from the unadjusted rate. A spread of 2% will reduce the unadjusted rate from 22.48% to 20.48%. It reduces the rate credited to customer. This could be a guaranteed (fixed) or non-guaranteed rate (changes over time).

Participation Rates - this is the percentage of the unadjusted rate that is applied.

A 80% participation rate means 22.48% x 0.8 = 17.98%. 

A 100% participation rate means 22.48% x 1 = 22.48%. 

A 150% participation rate means 22.48% x 1.5 = 33.72%.

Cap Rates - the upper limit on the interest rate used to credit interest on the funds allocated to the index strategy. This is the late thing that will be applied to the rate. If the Cap Rate is set to 15%, 22.48% will be 15%. Rate below 15% will be as-is. If there is no Cap Rate, we usually call it uncapped which means no limit on upside.

Minimum Guaranteed Interest Rate - the minimum guaranteed interest rate credited regardless of the index performance. e.g. 0.5%

All of the above can be applied or partially applied depending on your insurer. In order to find out the rate, you will need to review your annuity contract on all 4 of these if applicable and review them. The following are some examples to demonstrate how you carry out the calculation to derive the final rate. Assume you have cash value $10,000 as of 2019 Feb 6th e.g.

An unadjusted rate 22.48%, spread of 2%, participation rate 80%, cap rate 20% will derive (22.48% - 2%) x 0.8 = 16.38%. Index credited amount = $10,000 x 16.38% = $1,638. Minimum guaranteed interest credited amount = $10,000 x 0.5% = $500. The total credit amount is $1,638 + $500 = $2,138.

An unadjusted rate 22.48%, spread of 2%, participation rate 120%, cap rate 20% will derive (22.48% - 2%) x 1.2 = 24.57% and cap at 20%. So this will derive 20%. Index credited amount = $10,000 x 20% = $2,000. Minimum guaranteed interest credited amount = $10,000 x 0.5% = $500. The total credit amount is $2,000 + $500 = $2,500.

If the unadjusted rate is negative which means the end-term index is lower then the start-term, the rate is 0%, however, since the minimum guaranteed interest rate in this example is 0.5%, you still get 0.5% credit. Index credited amount = $10,000 x 0% = $0. Minimum guaranteed interest credited amount = $10,000 x 0.5% = $500. The total credit amount is $0 + $500 = $500.

I hope this article provides some basic concept on the terminology "rate" with some context. If you would like to understand how it works, please consult a qualified life agent and financial advisor to walk you through these. I think the best way to learn is to look at a real financial product where you can determine your suitability and learn how these rates work from a professional.

References

Participation Rate - https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_indexedannuities#:~:text=Participation%20Rate.,x%2075%25%20%3D%207.5%25).