Should You Consider a High Yield Annuity?
High yield annuities offer interest rates, on average, that are anywhere from a half a point to two points higher than those offered through bank CDs. The same spread exists between high yield annuities and regular fixed yield annuities. Those types of interest rate differences can translate into a substantial advantage in accumulated earnings over time. But, as with anything in life, there are no free lunches, and in order to gain an advantage in one area, you are likely going to have to give up something in another. High yield annuities do offer very appealing rates, but it is important to know a little more about what’s under the hood of the annuity contract.
What to Look for in High Yield Annuities
The Promotional Rate
The fixed annuity market is extremely competitive with hundreds of products vying for your money. While there are many ways to measure how competitive an annuity product is, the one feature that is used to get your immediate attention is the initial yield. To stand out from the rest, annuity providers are willing to put up promotional rates, typically a half to a full point higher than the prevailing market rate. The rate is designed to lure you in but it is important to read the fine print. In most cases, it is only guaranteed for a short period of time, usually a year, at which point it is then adjusted. It is important to know what happens at the rate adjustment. It is not uncommon for a provider to lure you in with a very high first year rate only to adjust the rate below market rates in order to recoup their loss on the initial rate.
The Fixed Rate Guarantee
Most high yield annuities are structured with multi-year rate guarantees. The provider is willing to guarantee a high yield for a fixed period of time because it is counting on keeping your money longer. This enables them to invest their portfolio in longer term bonds which can generate higher yields. The rate guarantee periods range from a year to 10 years. Generally, the longer the rate guarantee period, the higher the rate guarantee. Again, it is important to understand the fine print in some annuity contracts in which a multi-year rate is offered, but only guaranteed for a limited number of years. For example, you might see an annuity advertising a 10 year rate of 4%, but the actual rate guarantee is only good for three years.
Because the fixed rate is only payable for a certain period of time, it is also important to know how the provider goes about adjusting their rates, and what the minimum rate guarantee is. While it is always in the interest of the provider to remain as competitive as possible – after all, you can simply transfer your annuity funds to another annuity if you’re not happy – they may need to drop their rate below the market in order to recoup any losses from the higher rate. Also, some annuity providers are braced for the possibility that you may want to transfer your funds with higher surrender fees. Surrender fees, which are charged for withdrawals made during the surrender period that are in excess of 10% of the account value, tend to be higher in high yield annuities with long multi-year guarantees.
It is recommended that you shop for high yield annuities by comparing both their fixed rate guarantees and their minimum rate guarantee. If the initial fixed rate guarantee is inadequate, you might be better off looking for annuities that offer the highest minimum rate guarantees. Also, if you are concerned with being able to withdraw your funds or transfer them to another annuity at some point, you will want to shop for annuities with the most liberal surrender provisions – meaning lower fees or shorter surrender periods. Most people who invest in annuities do so with long time horizons, so they usually don’t concern themselves with the surrender provisions.
Finally, keep your eye out for bonus rates offered on larger deposits. These could add anywhere from a half to a full point to your yield which will make a substantial difference in your long term accumulation. Bonus points don’t become available until the deposit amounts exceed $50,000 or $100,000, depending on the provider. So, if you’re considering investing $40,000 into a fixed annuity, you may want to consider allocating another $10,000 from your savings account if it means adding an extra point to your yield.
Keep an Eye on Expenses
When you find a high yield annuity that offers a “too-good-to-be-true” guaranteed rate, the first place to look is at its expenses. We already discussed the surrender provision which is one way they can recoup the cost of the higher yield. The other place is with the annual expenses. Annuities do have certain expenses that are paid for out of your account value each year. Expenses for mortality (to cover the cost of the death benefit), and administration are paid as percent which can range from .05% to 1.2% per year. An annuity that offers a high initial yield for a period of time may be enticing until you find that its annual expenses are higher than the norm. The problem is that the high fixed yield may not stay high, but your annual expenses will. Better to shop for the lowest annual expenses because these could have a bigger impact on your accumulation over the long term.
There’s more to High Yield Annuities than Yield
Sure we all want the highest possible return on our money. But to get something really good, you usually have to give up something – it’s the old risk-reward continuum. You can find some very high yields on today’s annuities, but you just need to be aware of the costs. A high initial yield with a low minimum rate guarantee may not be a good trade off if you think interest rates may fall in the future. A ten-year rate guarantee may seem attractive unless we enter a period of rising interest rates in which you would have locked yourself into a lower rate. That big promotional rate may be the lure that locks you into some very rigid surrender provisions.
The point is that high yield annuities are a great alternative for safety conscious people who don’t want to completely sacrifice a reasonable rate of return. As with any investment, it is important to understand everything there is to know in terms of the upside and the downside.
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