To understand how interest rate floors work, you need to know a little bit about the types of annuities and how interest is credited to each.
- Fixed Annuities (FIAs)
- The insurance company sets a declared rate that is credited for the guaranteed term. The term is typically one year for traditional fixed annuities and three to 10 years for multi-year guaranteed annuities.
- Interest is credited based on the performance of a stock market index. Most indexed annuities also offer the option of allocating a portion of the premium to a bucket of fixed investments. In such cases, the annuity uses an indexed strategy and a fixed strategy. The funds allocated to the fixed bucket earn interest in the same way traditional fixed annuities earn interest.
- Unless it allows you to allocate a portion of your premium to a fixed account, a variable annuity will have no minimum guaranteed interest rate. It will, however, have unlimited upside potential because interest is credited based on the performance of the selected investments. According to the U.S. Securities and Exchange Commission, “the money in the [variable] account will vary according to the amount of premiums you pay, the amount of contract fees and expenses, and the performance of the investment options you choose.”
In addition to these basic interest crediting methods, specific pricing levers make it possible for insurance companies to provide their clients with annuity income benefits. One of these levers is the interest rate floor.
What Is an Interest Rate Floor?
An interest rate floor is simply a minimum interest rate that is credited to an annuity’s underlying investment portfolio. Regardless of the market and the performance of the insurance company’s own investments, it must honor the minimum interest rate stated in the contract.
According to Wink Intel, fixed and multi-year guaranteed annuities generally offer a minimum guaranteed floor of 1 percent or more, whereas indexed annuities offer a guaranteed floor of no less than 0.00 percent.
This floor protects the annuity owner from the negative effects of declining interest rates. Thus, fixed annuities are considered a safer option than variable annuities.
Indexed annuities, which are also subject to caps, spreads and participation rates, are considered moderate-risk products. The average interest rate floor for an indexed annuity ranges from 1 to 3 percent on at least 87.5 percent of the premium paid.