What is the Assumed Interest Rate?
An assumed interest rate is used to calculate an annuity's periodic income payments.
How Does the Assumed Interest Rate Work?
To understand how the assumed interest rate works, one must first remember how an annuity works. It's a contract between an individual (the annuitant) and an insurance company (usually). The insurer agrees to pay the annuitant a certain amount of money for a specific number of periods.
When the annuity is variable, the annuitant receives a minimum guaranteed periodic payment as well as excess payments that correspond with the performance of the annuity's underlying investments. So, an assumed interest rate of 5% on $1 million of principal would generate larger minimum payments to the annuitant than if the assumed interest rate were only 2%. Although the annuitant would receive additional payments if the annuity's underlying assets outperform certain expectations, the assumed interest rate specified in the annuity contract determines the minimum guaranteed payment (the annuitant's age, the type of annuity contract, and whether the annuitant's spouse will receive annuity payments if the annuitant dies also affect this payment).
Why Does the Assumed Interest Rate Matter?
In general, the larger the assumed interest rate, the larger the periodic payment to the annuitant. But because the insurance company (or the entity providing the annuity to the client) determines the assumed interest rate, it pays to shop around. After all, annuitants often use annuity income to fund their retirements, and because the assumed interest rate heavily influences the size of that income, it is of great importance. If the assumed interest rate is too low, the annuity payments may not be very large, especially after the annuity's fees and expenses are deducted.
