How annuities are impacted by interest rate cuts

Annuities are a way to secure a steady income stream in retirement. But like many investments — including bonds, savings accounts and certificates of deposit — certain types of annuities are impacted by interest rates. 

With the Federal Reserve almost certain to start cutting interest rates in September, many investors may be wondering if now is a good time to buy an annuity. 

Here’s everything you need to know. 

How do lower interest rates impact annuities?

Each insurance company sets its own rate of return on annuities. For fixed and immediate annuities, that rate is correlated to the federal funds rate. 

“Lower interest rates lead to lower payouts because the insurance company can’t earn as much when investing the premiums,” says Wade Pfau, director of retirement research at McLean Asset Management. 

In March 2022, the Federal Reserve began hiking rates to curb inflation, and since then, annuity sales have boomed. Suddenly, many immediate and fixed annuity products were offering their best guaranteed payouts in years, which led to record-breaking sales numbers as consumers lined up to lock in historically high rates. 

But the boosted payouts offered by annuities with fixed rates won’t last forever. Here’s a breakdown of how lower interest rates are likely to impact different types of annuities.  

Fixed deferred annuities

After years of laughably low rates, fixed-rate deferred annuities are having a moment. For people approaching retirement, the thought of locking in a 6 percent return is much more appealing than securing a 2 percent return. 

Sales of fixed deferred annuities (FDAs) have grown in lockstep with the rising federal funds rate. In 2023, FDA sales topped $164.9 billion, up 46 percent from the record set in 2022, and more than triple 2021 sales of $53.1 billion, according to data from LIMRA, an insurance trade association.  

Fixed deferred annuities allow you to postpone income payments for a specific period. During this deferral phase, your annuity accumulates interest. As the term “fixed” implies, your rate is generally locked in when you sign your contract, at least for a few years, after which time the insurance company can adjust it. So it can make sense to purchase a fixed deferred annuity when rates are higher, not lower. 

“Declining interest rates will translate into less generous returns on fixed annuities, much like you’ll see with cash and bonds,” says Greg McBride, Bankrate’s chief financial analyst.

And keep in mind that rates on fixed deferred annuities may already be priced lower ahead of the September Federal Reserve meeting. 

“Some lowering has already occurred in anticipation of rate cuts,” says Scott Witt, an actuary and fee-only insurance advisor at Witt Actuarial Services. 

Fixed deferred annuities often come with a guaranteed minimum interest rate — the lowest rate the annuity can earn. So even as rates go down, you’ll still earn a certain percentage. 

For example, if you purchase a 10-year fixed deferred annuity with a guaranteed interest rate of 3 percent, your annuity will earn interest at that rate regardless of market turbulence or rate cuts. While this may be lower than what you could earn in a higher interest rate environment, it still offers a certain level of protection against declining rates and market volatility.

Impending rate cuts won’t impact you if you already own a fixed deferred annuity. So long as your annuity has a guaranteed payout with a rate that doesn’t expire or reset, you’ll keep your current rate, regardless of what action the Fed takes. 

Single-premium immediate annuities

With a single-premium immediate annuity (SPIA), you make a one-time payment to an insurance company, and in return, the insurer provides you with a guaranteed income stream, usually beginning within a year of purchase.   

Interest rates play a big role in determining the income you’ll receive from a SPIA. When interest rates rise, insurance companies can invest your premium more profitably in conservative investments. This often translates into higher lifetime income for you.   

On the flip side, when interest rates fall, insurers may earn less on your investment. This can result in lower income payments.

This is illustrated in a 2021 research paper by MIT economists, which showed that a substantial decline in nominal interest rates is associated with lower annuity payouts. 

For example, the average annual payout on a $100,000 SPIA for a 65-year-old man was $5,748 in June 2020, compared to $6,456 in June 2015 and $7,740 in June 2005. Your payout would have been 34.7 percent larger if you had purchased the SPIA in 2005 (when 10-year Treasury bonds averaged 4 percent) versus 2020 (when 10-year Treasury bonds averaged 0.73 percent).

“For an immediate annuity, you are generally locking in to an assumed rate for the life of the product, so the underlying rate assumption is more critical,” says Witt. 

He adds: “But it’s also important to note that those annuity rates are much longer, and a short-term rate cut doesn’t necessarily impact the entire yield curve identically.”

Multi-year guaranteed annuities

Multi-year guaranteed annuities (MYGAs) are another option to explore. With a MYGA, the insurance company guarantees the safety of your principal and adds some interest to your account. The interest rate can be guaranteed for one year or longer, depending on the terms of your contract. 

MYGAs with terms one year or longer typically offer higher yields than comparable bank CDs. Another perk is you can defer taxes on the interest as long as it remains in the account.

MYGAs are ideal for locking in a guaranteed yield while safeguarding your principal. So, as many people flock to CDs, it can make sense to buy a MYGA before interest rates drop significantly. Just keep in mind that some annuity providers may have already lowered rates on MYGAs in anticipation of rate cuts, meaning you might not get a rate as high in September 2024 as you would have a year prior. 

How important are interest rates when buying an annuity?

Interest rates are important to consider when purchasing an annuity. Higher interest rates generally lead to higher income payments from SPIAs and better interest accumulation on FDAs and MYGAs. Meanwhile, lower interest rates can result in lower income payments and interest accumulation.

While interest rates are important, they’re only one piece of the puzzle. Your age and gender also play significant roles.

Your life expectancy and age are the primary concerns for an insurance company trying to determine the guaranteed income to provide you through an annuity. They estimate how long they’ll be responsible for paying out benefits, so interest rates are more of a secondary consideration. 

“Older individuals can expect higher payouts because they’re not expected to live as long,” says Pfau. “Women live longer than men, so they have lower payouts.”

Another thing to keep in mind is that insurance companies tend to focus on the long-term investment returns an annuity generates rather than short-term interest rate fluctuations.

Life insurance companies mostly invest in corporate bonds, government bonds and mortgage-backed securities, so they’re trying to project how these conservative fixed-income investments will perform over the next decade or more.

In other words, the September Fed rate cut won’t likely have a dramatic immediate impact on annuity rates, says Witt. 

“Generally speaking, annuity rates are going to be somewhat sticky and not respond to every single interest rate change,” says Witt. 

Is now a good time to buy an annuity?

With the Fed expected to cut rates in September, now may be a favorable time to lock in a higher rate on fixed or immediate annuities. 

“If someone is in the market right now for one of those products, it may be better to act sooner rather than later,” says Witt. 

But, he cautions, the decision to buy an annuity depends on your specific circumstances and risk tolerance.

“If you aren’t interested in an annuity, I don’t think someone should rush out to buy one just because of an anticipated rate cut,” says Witt. 

Instead, if you’re worried about market volatility and the potential for outliving your savings, an annuity might make sense. 

Just keep in mind that not all annuities are created equal, so it’s important to be aware of potential downsides. Annuities often come with surrender charges and commissions, and they limit access to your money. 

Not all types of annuities are impacted by rate changes, either. Variable annuities, for example, are less sensitive to interest rate fluctuations because their returns mostly hinge on the performance of underlying mutual fund-like investments, not prevailing rates. 

However, variable annuities tend to be the most complex, expensive and risky type of annuity. When rates are low, people are more likely to pile into variable annuities in an attempt to capture higher returns. 

But recent high interest rates have given investors better opportunities to generate safe returns than they had a decade ago, which has led to a slowdown in traditional variable annuity sales. In 2023, variable annuity sales dropped 17 percent from the prior year, while fixed deferred annuity sales rose 46 percent during the same time and SPIAs set a new annual sales record, according to LIMRA. 

Speak with a financial advisor who can assess your specific situation and determine if an annuity is the right choice for you.

Bottom line 

With the Federal Reserve signaling upcoming interest rate cuts, now might be the last chance to lock in higher returns on certain annuities. If you’re considering securing a steady income stream in retirement, it’s worth exploring options like fixed and immediate annuities before rates potentially fall. 

However, remember that annuities aren’t a one-size-fits-all solution. Before making any decisions, consult with a fee-only financial advisor to determine whether an annuity aligns with your goals and risk tolerance.