7.6 Fixed Annuity
If a set rate of return is desired, the contract owner can choose the fixed annuity. This type of annuity guarantees that the money will accumulate at a minimum specified rate of interest. However, the insurance company will pay a higher rate of interest if its investment experience is better than the minimum guarantee.
The fixed annuity is best known for its guaranteed rate of return feature; however, it actually provides two types of interest rates.
- A minimum guaranteed rate
- The current interest rate
Regardless, there is no possibility of loss. The insurer bears the burden of risk.
Julie purchased an annuity with a minimum guaranteed interest rate of 4%. For the first two years, the current interest rate was 5%, so Julie's accumulated funds grew by 5% each year (1% above the minimum guaranteed rate of interest). In the last two years however, the current interest rate went down to 3%, but Julie's annuity continued to grow at 4% (the minimum guaranteed rate of interest). The insurer absorbed the 1% loss of those years.
Premiums paid for fixed rate annuities are invested with the insurance company's general funds, chiefly in fixed income types of securities, typically bonds, with the ultimate purpose of providing a level annuity income. Bonds are a stable investment for fixed rate annuities due to the fact that bonds carry a fixed rate of return and a principal maturity date.
