Does an Annuity Make Sense with Low Interest Rates?

Yesterday, I spoke with a Mr. Jim Lankford. Jim found our toll-free number on the web. He said he was 64, had recently retired and called to ask my opinion about whether he should wait until rates improved before buying an annuity.

In our conversation, I learned from Jim that he had been researching annuities for a year or so and was thinking of buying an immediate annuity with 30% of his 401k money. He said he was ready to go ahead but his former work colleagues kept telling him not to buy right now. They said he should wait until next year when interest rates will be higher. This, of course, would give him a better return.

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As you'd expect, Jim's question is one I hear practically every day. Of course, I couldn't tell him where interest rates would be in a year from now. How could I know?

In which direction are interest rates headed?

On the surface, waiting for higher rates sounds very appealing. After all, most people believe the income they receive from an annuity depends on two factors: (1) the level of interest rates when they buy their annuity and (2) their age when they buy their annuity.

So, their reasoning goes, if I wait for interest rates to rise, I'll receive a larger monthly payment because I'll lock in a higher rate plus I'll be that much older.

There are, however, several problems with this line of reasoning.

First, you could be in for a long wait. The following is a chart of 30-year bond interest rates.

(Click here to see the current chart)

Imagine if you called me back in 1990 when interest rates were 8%. You'd have a memory of how high rates were just 5 years earlier, in 1985. They were 13%.

Do you think you would have locked in an 8% annuity rate in 1990? Or, would you have thought "An 8% rate is pretty low. I'm going to wait for rates to move back up to 13%."

So what happened to interest rates in 1990?


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Comments (4)

  1. Christian
    2015-05-06 14:52:24

    You mentioned near zero interest rates in Japan as an example to counter the assertion that interest rates can't go any lower from where they're at now. That's an unfair comparison. Japanese interest rates are near zero because of the Bank of Japan's radically unorthodox monetary policy and the economic factors affecting Japan couldn't be further from those affecting the US.

  2. Hersh Stern (
    2015-05-06 14:53:16

    Hi Christian-

    Low interest rates in Japan is not a recent phenomenon. Japanese interest rates have been below 1% for more than 20 years. And while it's true recently that all the world's central bankers have been pushing interest rates lower in their respective countries, Japan's economy has been in a deflationary funk for more than two decades due to economic stagnation and demographic factors, both of which plague the US economy too. So our interest rates could stay low for a protracted period, too.

    It wasn't my intention in the article to predict the direction of interest rates. I'm just giving everyone a heads-up that interest rates could stay low for a lot longer than we imagine.

    Remember when the NASDAQ was doubling in value each year between 1998 and 2000 and home prices were increasing at 20% a year in some places between 2003 and 2007? Well, with that kind of price inflation, nobody could predict that the US Treasury's 10-year T-note which was at 6.00% then could drop to 1.50% in short order. Yet, that's exactly what happened a few years later.


  3. Paul
    2015-06-08 15:10:29

    How does a rising interest rate environment impact the monthly payment of a Deferred Income Annuity (DIA). In other words, if the 10 year treasury today is 2.4% and I expect it to be 3.5% a year from now, would it be better to wait a year before purchasing the DIA because the monthly payments would be higher, or is the interest rate irrelevant with a DIA?

  4. Hersh Stern (
    2015-06-08 15:12:19

    Hi Paul-

    The interest rate in effect at the time you buy your annuity has a big impact, even with a DIA. Here are some of the factors to weigh--

    1. How long do you plan to delay the income? If you plan to defer income for 5-10 years then the insurance company would have a substantial opportunity to grow your premium at that future higher interest rate. So the company would promise you a higher monthly income when you apply for your annuity knowing it can earn more interest during the 5-10 years. However, if you're only delaying the income for one or two years then the compounding effect would be less important and you might as well buy your annuity today.

    2. How is your money currently invested? In other words, what's the alternative to the insurance companies' growth factor? If your money is in a money market account or certificate of deposit and earning little interest then you are a lot more likely to earn more with an insurance company. However, if you are a "hot hand" investor and you're earning 15%-20% a year in the stock market, well you know where's the best place to keep your money.

    3. How confident are you that interest rates will actually be higher a year from now? The best bond market prognosticators have been wrong these past five years in calling an upturn in rates. So what's your "plan B" if a year from now the 10-year treasury note is at 1.5%? That could happen.