Annuity companies vary on how much they expect to earn on investments. One might require 13%, whereas another wants 11%. These returns can influence how they'll invest your money and the renewal rates you'll receive.

Suppose you're looking to put money into a tax-deferred annuity and you've narrowed down your choice to four products in two categories: two fixed annuities and two index annuities. Each annuity has the same initial interest rate, the same minimum guarantee rate, the same surrender charge and the same withdrawal features as the other in its category. They appear to be virtually identical, but will they pay the same renewal rates when the initial rate term is up in, say, one year? It's doubtful. Let's look at why and how this happens.

Fixed Annuities
Regulations require that annuity companies invest most of their portfolios in bonds. As such, they won't have much in stocks, real estate, or other assets. However, the companies have flexibility on the quality and average maturity of those bonds. Consequently, they can alter the yield and the risk.

Yield vs. Ratings
The higher a bond's rating, the lower the yield. The return is less because there is less chance the bond issuer will default. As a result, the managers of a fixed annuity might buy only high-grade bonds, such as 'AAA' rated bonds and accept lower returns. Conversely, another company could be willing to accept more risk in return for higher renewal yields than its competitors.

Yield vs. Maturity
Generally, the longer a bond's maturity, the higher the yield.

To keep the numbers easy to work with, let's say the two fixed annuities you're checking out look like this:

  • Annuity No.1: 10-year average maturity portfolio that pays a 5% initial rate
  • Annuity No.2: 20-year average maturity portfolio that pays a 5% initial rate

Suppose we look ahead a year. The initial rate guarantee has now passed and prevailing rates have dropped. Here's what the renewal rates could be:

  • Annuity No.1: 4%
  • Annuity No.2: 5%

Annuity No.1's rate dropped because its bonds are close to maturity, and the money might have to be reinvested at the current, lower prevailing rates.

On the other hand, Annuity No.2's managers have time on their hands - an extra 10 years, in fact. As such, they don't have to worry as much about reinvesting money right now.

But what happens if prevailing interest rates skyrocket over the first year? For our example, the renewal rates could be:

  • Annuity No.1: 6%
  • Annuity No.2: 5%

Because Annuity No.1's portfolio will have a number of bonds maturing soon, it will have cash to reinvest at the higher prevailing rates. Conversely, Annuity No.2 will continue to pay the same rate based on its longer term portfolio. Plus, if it does not sell its long-term bonds to reinvest at higher rates, it might face a loss if those bonds drop in value. (To learn more about fixed annuities, see Watch Your Back In The Annuity Game, Exploring Types Of Fixed Annuities and Selecting The Payout On Your Annuity.)

Index Annuities
Index annuities offer the potential to participate in the growth of an index, such as the S&P 500. Index annuity managers have to consider issues that differ from fixed annuities when they calculate renewal rates.

When the initial rate has expired, you might have to face changes in the following:

  • Cap: The maximum interest rate you can earn
  • Participation Rate: The percentage of the index's growth used to determine the interest credited for the year or for the index period
  • Spread: The amount deducted from the index's growth to calculate the interest credited for the year or the index period

The portfolio managers buy options to give you index-linked growth potential, but the options can have several variations that could make a difference in your renewal rates. (To read more about options, see our Option Spread Strategies tutorial.)

Exchange-Listed Options
Options that trade on an exchange, such as those listed on the Chicago Board Options Exchange, can cost less than synthetic, over-the-counter options created by sellers. And lower costs can mean higher caps or participation rates at renewal time.

Big Buyers
There are discounts for annuity companies that buy large numbers of options. If your index annuity's managers go in with $50 million in hand, they'll get more options for their money than they would with just $10 million. And you'll stand a better chance of higher caps or participation rates.

Dynamic Hedging
Your index annuity's managers might not even buy options. Instead, they may seek to duplicate an option's performance by putting together a portfolio of other investments. This could increase returns, which might lead to lead to higher caps or participation rates. Or it might increase the risk that your renewal rates could drop. (To keep reading about annuities, see Taking The Bite Out Of Annuity Losses and An Overview Of Annuities.)

To help you through your decision process, you can ask your annuity company for its rate renewal history. You can also try to find out what type of bonds it holds and whether options are used. However, it often just comes down to the people who manage your annuity because people, with their emotional biases, make the final decision on where to invest and ultimately set the renewal rates.

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