What Is the Assumed Interest Rate (AIR)?
The assumed interest rate (AIR) is the rate of interest (or growth rate) selected by an insurance company. The assumed interest rate is provided to determine the value of an annuity contract and, therefore, the periodic income payment provided to the annuitant. Combined with other factors such as the annuitant's age upon annuitization, spousal coverage options and the type of annuity coverage chosen, the AIR determines the monthly payment the annuitant will receive. Insurance companies use the AIR to calculate the value of an annuity.
Many investors use annuities to generate retirement income, and knowing the AIR can help such annuitants plan financially for their retirement years because it lets them know how much they can expect to receive from an annuity. Calculating the value of an annuity also lets investors plan additional investments in other vehicles.
Understanding the Assumed Interest Rate (AIR)
The assumed interest rate (AIR) is the minimum interest rate that must be earned on investments in the policyholder's cash-value account in order to cover the insurance company's costs and expected profit margin. A larger AIR will result in a more robust prediction for market returns, as well as greater monthly income payment for the annuitant.
The AIR is not a guaranteed rate of return. Rather, it is an earnings target that the insurance company sets for the annuity account. The account must meet this earnings target in order maintain payment levels. As annuity value changes, the payment received by the investor changes. If the account outperforms the AIR, an investor can expect his or her payments to increase in size. If performance falls below the AIR, payments will decrease in size. Performance is always measured against the AIR, not past performance.
An annuity payment is based on the number of annuity units owned by the investor, multiplied by the annuity unit value. When performance equals AIR, annuity unit value remains unchanged, and so will the investor's payment. Thus, selecting a realistic AIR is very important.
If the AIR is too high, the value of the annuity unit will continue to fall, along with the investor's payment. If the account outperforms the AIR, the value of the annuity unit will continue to rise, and so will the investor's payment. The AIR is only relevant during the payout phase of the contract when the investor is receiving payments and owns annuity units. The accumulation of units during the accumulation stage – or if benefits are deferred – is immaterial to the assumed interest rate.
Real World Example of an Assumed Interest Rate
As a hypothetical example, assume a variable annuity, where the annuitant receives a minimum guaranteed periodic payment that is tied to the performance of the annuity's underlying investments. An assumed interest rate of 5% on $1 million of principal would thus generate larger minimum payments to the annuitant than an annuity performing at 2%. Although the annuitant can receive additional payments if the annuity's underlying assets outperform expectations, the minimum guaranteed payment is tied to the assumed interest rate.