How Do Interest Earnings Accumulate in a Deferred Annuity?
Deferred annuities are a popular retirement option. They can also be complicated. If you want to retire wealthy or at least financially stable, here’s what you need to know about deferred annuities, and how their interest earnings accumulate.
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What Is a Deferred Annuity?
An annuity is a contract between an individual and an insurance company. The individual gives the insurance company a sum of money, either all at once or in periodic payments. Then, at a future point in time, the annuity company pays the individual a series of payments that, in most cases, are guaranteed to last for the rest of the individual’s life.
The “future point in time part” is what makes it a deferred annuity. There are also immediate annuities, which begin to pay out right away, within a month or a year of the purchase of the contract, depending on how frequently the payments are made.
How Do Earnings Accumulate?
When you purchase an annuity, the money you pay — the premium — is invested, either in a fixed investment or in variable investments like mutual funds. When talking about interest earnings, the underlying investment is fixed, with a guaranteed interest rate. The interest rate is typically set for a period of time, often one to five years, and will not change during that time.
Once that period has ended, the interest rate may adjust depending on the current market. Most fixed deferred annuities have a minimum guaranteed rate, where the interest rate won’t drop, regardless of any changes.
The interest rate for a fixed deferred annuity is often specified in the contract. It’s usually tied to an external rate, such as the prime rate or the Secured Overnight Financing Rate, or SOFR. For example, the contract may state that the interest rate will always be SOFR plus one percentage point.
Understanding Fixed Annuity Fees
There are fees or costs associated with all annuities, but fixed annuities are often advertised as being “no-fee.” There can be, however, costs associated with them. Here’s what you should know about annuity fees.
Surrender Charges
A surrender charge is the cost you pay if you withdraw funds from your annuity contract before a certain period of time. Annuities are designed to be long-term investments, so annuity companies may charge 5-7% or more for withdrawing your money early. Surrender charges decline over time. After a set period, they’ll go to zero. The easy way to avoid surrender charges is to leave your money in the contract until the surrender charge expires.
Administrative and Other Fees
Commissions, administrative and other fees are typically built into the annuity contract, so you don’t see them on your monthly statement. What you end up paying includes the fees paid by the annuity company. It covers the spread between the interest rate they pay and they money they earn on your investment as well.
You could get a slightly higher interest rate elsewhere, but you won’t get the other benefits of an annuity, like the guaranteed income payments. So in that sense, the annuity company “reduces” your return.
It’s important to understand how your earnings accumulate when you purchase an annuity. Read the fine print before you buy, so that your potential annuity will do everything you expect.
This article originally appeared on GOBankingRates.com: How Do Interest Earnings Accumulate in a Deferred Annuity?
