When you’re considering buying into an annuity, it’s natural to wonder what kinds of returns they typically attain. The rate of return is an important factor in the growth of their portfolio and how much income will be received in retirement. However, any fees you encounter will eat into your returns. You should also know how to calculate the average rate of return on your annuity. You can work with a financial advisor to understand and use all key gauges for evaluating an annuity.
Average Rate of Return for an Annuity
There are three basic types of annuities and each one has different rates of return for the annuity owner. The average rate of return you receive depends on the amount of risk you are willing to take with your account.
Fixed Annuity
Fixed annuities are similar to bank certificates of deposit (CDs) because they offer a guaranteed rate of return. These are generally the safest annuity investment and are backed by the financial strength of the insurance company. While you will not receive outsized returns, you do not have to worry about your account value dropping either.
Many investors choose fixed annuities to provide a steady return to balance the risks associated with their stock portfolio. The guaranteed income from a fixed annuity gives investors peace of mind through the ups and downs of the stock market.
The average return of a fixed annuity varies based on the term of your annuity. In general, though, the longer your contract’s term is, the better the rate you’ll receive. Remember that any fees you encounter will shrink your returns, though.
Variable Annuity
A variable annuity invests in separate accounts that are similar to mutual funds. These separate accounts can invest in stocks, bonds and other assets that can fluctuate in value. Variable annuities offer a selection of investments that represent different sectors of the market. The options are typically a mix of stocks and bonds that are based in both domestic and foreign markets.
Investors choose variable annuities when they are willing to accept more risk for the opportunity to grow their balance faster. While there is upside potential, there are no guarantees of what the future value of the account will be. This uncertainty means that the investor does not know how much retirement income they can expect from their variable annuity.
Again, the average variable annuity rate of return depends on the investment options that you select. Variable annuities usually feature many choices, but returns are often similar to popular ETFs and index funds (8% to 10% annually, on average). Your contract fees and investment expense ratios will eat into these returns, though.
Indexed Annuity
Equity indexed annuities were created to give investors the upside of the stock market with the guarantees of a fixed annuity. Their returns are tied to a specific index, like the S&P 500. These annuities participate in the stock market returns, while generally guaranteeing a minimum rate of return when stocks fall. Sometimes this minimum rate of return is zero. While this means that you don’t earn anything that year, it also means that you won’t lose money either.
The downside of equity-indexed annuities is that you only participate in a portion of the stock market’s growth. Additionally, there’s usually a cap on your maximum return. This means that, no matter how much the stock market increases, your return will not go higher than your cap. For example, let’s say that the stock market increases 20% and you have 75% participation and a 12% cap. Your participation limits your return to 15%. Yet, the 12% cap means that your maximum return can only be 12%.
The average equity-indexed annuity rate of return varies based on the stock market’s performance, your participation rate and your cap. Again, these returns are entirely dependent on the specifics of your annuity contract.
How to Calculate Your Rate of Return
There are two rates of return for your annuity. The total rate of return tells you how much your annuity contribution has increased, while the compound annual growth rate is the average amount is grew each year.
Total Rate of Return
To calculate the total rate of return of your annuity, follow this simple formula. Take the annuity’s current value minus your contribution, then divide that total by your contribution. Multiply the result by 100 to get a percentage value.
The total rate of return formula is (Current value – Contribution) / Contribution x 100. For example, ($500,000 – $400,000) / $400,000 x 100 = 25%.
While the total rate of return provides the return for the entire time that you hold investments, it does not provide the average annual rate of return for your investment. To get that number, you would need to use the compound annual growth rate formula.
Compound Annual Growth Rate
For your annuity’s compound annual growth rate (CAGR), here is the formula. You then divide the current value by your the starting value. Then raise the result to the power of one divided by the number of years you were invested. Subtract one from your result. The formula looks like this (Ending balance / Starting balance) ^ (1 / Years) – 1 = compound annual growth rate (CAGR). If it took 4 years for your contribution to grow from $400,000 to $500,000, the CAGR formula looks like this ($500,000 / $400,000) ^ (1/4) – 1 = 5.7%.
In other words, you would need to average a 5.7% return for four years to grow $400,000 to $500,000.
Bottom Line
Determining the performance of your annuity and how much income it will provide in retirement is an important calculation. The actual returns you receive depend on the type of annuity you choose, how long you invest for and the performance of the underlying investments. Many people choose fixed annuities for the guaranteed performance that balances out the risks of their stock portfolios.
Tips for Annuity Buyers
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Choosing which type of annuity is best for your situation can be a challenge. A financial advisor can describe the pros and cons of each and present solutions to match your needs. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Our retirement calculator will help you determine how much income you’ll need for retirement based on your assets, sources of income and expected expenses. Knowing your retirement income needs can help you decide if an annuity is right for you.
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