Rates rise after you buy: what happens to the fixed annuity you hold

Two years ago a hypothetical couple locked $100,000 into a seven-year fixed annuity at 4 percent. This week a neighbor mentions that new contracts are paying 6 percent. Does the couple feel foolish, and should they do something about it? The answer is that they have not lost money, and what they do next depends on three numbers in their own contract: the surrender charge, whether a market value adjustment applies, and how much they can take out each year for free. Doing nothing is a real option, and so is an exchange; the difference is arithmetic.

This post follows four hypothetical households through that decision. All of the rates, charges and schedules are invented to make the math easy to check, and none is a price from any company. Rising rates are not a certainty either; this scenario is one of many. Read how annuity rates are set and why they move for why rates move, and keep in mind that the right contract terms are the ones in your own paperwork.

The starting contract

Every household below holds a contract with the same illustrative terms.

• Premium: $100,000, a fixed annuity of the multi-year type (see Multi-year guaranteed annuities (MYGAs): how they work).
• Guaranteed rate: 4 percent a year, compounded annually, for seven years.
• Surrender schedule, charged on the amount withdrawn: 7 percent in year one, 6, 5, 4, 3, 2 and 1 percent in years two through seven, then zero.
• Free withdrawal: 10 percent of the value each year without a charge, when the owner takes a partial withdrawal.
• Two years have passed, so the contract is now in its third year and the charge would be 5 percent.

The value today is $100,000 × 1.04 × 1.04 = $108,160. If the owner simply waits until year seven, the contract grows to $100,000 × 1.04^7, or about $131,593. Everything that follows is measured against that "stay put" result, which is worth $131,593 at the end of seven years (five years from now).

New contracts, in this scenario, pay 6 percent for five years, an illustrative figure. The gap between 4 and 6 percent looks large, and it is, but a gap in rates is not the same as a gain in dollars. The cost of getting to the higher rate has to be subtracted first.

Household 1: Maria and Tom consider a full exchange

Maria is 64 and Tom is 66. They own the contract in a taxable account (a non-qualified annuity) and neither needs the money for at least five years. A new agent offers a 1035 exchange into a five-year contract at 6 percent. A 1035 exchanges: swapping policies without tax moves the contract to a new one without immediate tax on the gain, but it does not erase the old contract's surrender charge. The old insurer takes the charge out of the money it sends.

For simplicity, assume the old contract charges the 5 percent on the entire value when the contract is fully closed.

• Value today: $108,160.
• Surrender charge: 5% × $108,160 = $5,408.
• Amount sent to the new contract: $108,160 − $5,408 = $102,752.
• Value after five years at 6 percent: $102,752 × 1.06^5 ≈ $137,505.
• Value if they stay: about $131,593.
• Difference: $137,505 − $131,593 ≈ $5,912 in favor of the exchange.

On paper the exchange wins by about 4.5 percent of the stay-put value over five years. Before they act, Maria and Tom need to check five things that the paper result leaves out.

1. The new surrender period. The new contract has its own schedule. The couple has traded a contract that would be free in five years for one that is locked for five years from today. If they might need the money in year three, the next charge matters.
2. Break-even time. They start $5,408 behind. The extra 2 points a year take time to catch up. The exchange breaks even when $102,752 × 1.06^n equals $108,160 × 1.04^n. Solving that gives about 2.7 years. If they leave in year two, they lose.
3. Tax. A direct 1035 exchange defers tax. A surrender followed by a new purchase does not, because the gain, $108,160 minus $100,000 of premium and less the charge, becomes taxable income. Insist on a direct transfer.
4. The agent's incentive. A new contract pays a new commission; the insurer's rate and the agent's pay both depend on the sale. That does not make the advice wrong, but it is why replacement sales are regulated and why the guide on annuity surrender charges and free withdrawals suggests asking what the old contract's own terms will do first.
5. Rate risk goes both ways. The 6 percent is a rate for new money today. Rates could be 8 or 3 percent when the new contract ends. The arithmetic compares known guarantees, not forecasts.

The couple's decision list is short: if they will keep the money untouched for at least three years beyond today, if the exchange is a direct transfer and if the new contract's charges are no worse than the old one's, the exchange has a positive result in this example. If any of those fail, the $5,912 advantage shrinks or disappears.

Household 2: Dev moves the money a slice at a time

Dev is 67 and his contract is held inside an IRA, so it is a qualified annuity. He does not like the idea of paying $5,408 to leave. His contract allows a free withdrawal of 10 percent a year, a free withdrawal provision, and he can send that slice by direct transfer from one IRA to another, which is not a taxable distribution when it is done correctly.

Here is the drip. Each year he moves 10 percent of what remains in the old contract to a new 6 percent contract. The old money keeps earning 4 percent.

After five years Dev has about $135,011, compared with $131,593 if he had stayed and $137,505 if he had done a full exchange. He gives up about $2,500 of the full-exchange advantage and avoids the charge entirely. He also has no all-or-nothing moment: if rates fall, he can stop moving money, and what he has already moved has a head start.

There are limits to the plan. The free withdrawal may not carry over if he skips a year. It may be calculated on premiums rather than on the current value. Each new slice buys into a new contract that may have its own surrender schedule and minimum purchase amount. If this were a non-qualified contract instead of an IRA, a withdrawal would be taxed earnings first, as explained in taxing a non-qualified annuity withdrawal: gains come out first, and the tax could cancel the gain. The same drip is a good idea only where the transfer is tax-free.

Household 3: Priya has a market value adjustment

Priya is 61. Her contract is identical in rate and schedule, except that it has a market value adjustment (MVA) on withdrawals beyond the free amount. An MVA reprices the value of the contract to the current interest rate environment when you leave before the term ends. When rates have risen since you bought, the adjustment is negative. When they have fallen, it is positive.

Formulas differ among contracts. One common shape, which this example uses for illustration, multiplies the value by the ratio of the old rate to the current rate, raised to the number of years left, with a small margin added to the current rate:

• Years remaining: 5.
• Factor: (1.04 ÷ (1.06 + 0.0025))^5 = (1.04 ÷ 1.0625)^5 ≈ 0.8985.
• Value after adjustment: $108,160 × 0.8985 ≈ $97,183.
• Reduction: about $10,977, or roughly 10 percent.

In this example the MVA takes the place of the surrender charge. It is much larger than the 5 percent charge that Maria and Tom paid, and it leaves Priya with less than her original $100,000 premium. A full exit costs her far more than waiting. Some contracts limit the downward adjustment so that the value never drops below a contractual minimum; Priya's does not, so she should read her contract's language.

What the MVA does not do is touch the contract if she waits. At maturity the guaranteed value is paid in full, and most contracts waive MVAs and surrender charges at death. Priya's choice, then, is to stay, since exiting would turn a paper loss into a realized one. If she genuinely needs cash before maturity, the free withdrawal amount usually escapes the MVA, so she can start there.

Household 4: Elena holds a renewable-rate annuity

Elena is 70. Her annuity is not a multi-year guarantee. It is a flexible-premium fixed annuity whose insurer declares an interest rate each year, with a guaranteed minimum written into the contract. The current rate was set a year ago at 4 percent and the insurer will declare a new one at the next anniversary.

When market rates rise, a renewable-rate contract does not automatically follow. The insurer decides the declared rate within the contract's floor, taking into account its own investment yields, its competitors and how much new money it wants. Insurers often raise renewal rates more slowly than new-money rates, partly because the bonds backing older contracts were bought earlier at lower yields. There is no formula, so Elena has to ask.

What she can do:

1. Call the insurer and ask for the current declared rate, the date of the next reset, and the guaranteed minimum.
2. Ask whether there is a window around the anniversary during which she can leave without a charge or an adjustment. Some contracts have one.
3. Check the remaining years of her surrender schedule. If it ends in a year or less, waiting for it to run out costs less than any exit.
4. Compare the declared rate with new-contract rates, and then compare it with how much she values the access and the guarantees that she already has.

Elena's best step may be a question asked and answered in writing. Her contract may already be crediting something close to the market; or it may not, and she can wait for a window and decide. In neither case does she have to act this week.

Why your insurer cannot simply raise your rate

A natural question is why the insurer does not pay existing owners the new, higher rate. The answer is in how the money is invested. The insurer used the premiums from contracts like yours to buy bonds and similar assets that pay a known yield for years. Those bonds were priced at the lower yields of the time. If market yields rise, the bonds the insurer already owns are worth less if sold early, and the income they produce does not change. The company can only pay the higher rate on new money invested at the new yields.

That is also why the market value adjustment exists. When an owner leaves early after a rate rise, the insurer may have to sell some of those bonds at a loss, and the MVA passes part of that loss to the person leaving. The surrender charge covers a different cost, the commission and the expense of setting up the contract. Seen this way, the exchange to a higher-rate contract is not a free upgrade. It is the owner paying the old insurer for the right to start again at today's yields, and the new insurer pricing its contract on a fresh set of bonds.

What if rates keep rising, or fall back?

The scenarios above compare known guarantees, but the future rate environment is not known. Two possibilities are worth thinking through, with the same invented numbers.

Rates keep rising. Suppose that a year from now new contracts pay 7 percent. Maria and Tom's exchange to 6 percent would then look worse, since they would be locked in again. Dev's slice-by-slice approach would look better, because the later slices would go into the higher rate. Nobody can pick the peak, and an owner who waits for it may wait through years of lower credited interest. This is why the guide on how annuity rates are set and why they move suggests spreading purchases over time rather than timing a single move.

Rates fall back. Suppose instead that new contracts pay 3 percent a year from now. Maria and Tom's 6 percent contract looks good, the stay-put couple still holds a 4 percent guarantee, and Priya's MVA, which was negative, could turn positive. The owners who did nothing lose nothing. This is the main argument for patience: a guaranteed rate on the contract you already own is an asset whose value rises when market rates fall, even though a statement never shows it.

Either way, the end of the guarantee period matters most. At the end of year seven, the owner of a multi-year contract usually receives a notice and a window, often about a month, to renew, withdraw or exchange without a charge. At that point $131,593 can be reinvested at whatever rates then prevail, with no surrender cost to pay. Marking that date on a calendar, and asking the insurer how it will notify you, is among the most valuable things an owner can do. The choices at that point are covered in your multi-year guaranteed annuity is maturing: the choices ahead.

How the four households compare

The same rate change led to four different answers because the contracts differ in the three terms named at the start: the surrender cost, the MVA and the free amount.

A decision list you can use

1. Find the cost to leave today. Ask the insurer in writing for the surrender value after all charges and adjustments, and compare it with the account value.
2. Find the time to the end of the schedule. If the charge disappears within a year, the cost of waiting is usually small compared with the cost of leaving.
3. Check for an MVA and its floor. If one applies and rates have risen, assume exiting early is expensive until you see the number.
4. Compute the break-even. Divide the new value after costs by the old value, then find how many years the rate gap needs to close that ratio. If the answer is longer than you are sure you will hold the contract, do not move.
5. Check tax. Use a direct transfer or a 1035 exchange, never a cash-out followed by a purchase, and know whether a withdrawal would be taxed gains first.
6. Check the new contract. Look at its surrender schedule, its MVA and its financial strength. The guide on fixed annuities: how they work, what they cost, who they suit covers what to ask.
7. Check the incentive. Ask who is paid when you switch and how much. A good reason survives that question.
8. Think about what you need the money for. The reason you bought the contract may still matter more than a 2 percent difference in rate.

For a large contract or a complicated tax situation, a fee-only planner or a tax professional can run the specific numbers. Your state insurance department can explain the replacement rules that apply in your state, which in many states require written disclosure when a new annuity replaces an old one.

Key takeaways

• A rate rise does not reduce what your fixed annuity is worth at maturity; it changes what the contract could be sold for early and what a new contract would pay.
• The cost of exchanging is concrete. In the example, a 5 percent charge of $5,408 took about 2.7 years of a 2-point rate advantage to recover.
• Free withdrawals can move money in slices without charges, and they are tax-free only where the transfer is tax-free, as in an IRA transfer.
• A market value adjustment can turn a rate rise into a double-digit percentage loss on early exit, which makes waiting to maturity the cheaper path.
• With a renewable-rate contract, ask for the declared rate, the reset date and any exit window before deciding anything.