Annuity Accounts: Simple Vs Compound Interest

There are several ways to maximize your fixed annuity policy for growth and income. It’s important to select the right type of account based on your financial needs.

First, you should know that fixed annuities can credit interest in two different ways. Most grow through compounding interest, but there are some that credit simple interest only.

So which is better? It depends on your rate of return, but also whether you withdraw the interest. We’ll compare compound and simple interest annuities below and discuss which policies pay best in different situations.

Compounding Annuity Interest Accounts

Einstein said that compounding interest was one of the great marvels of finance. He was correct. But you can only take advantage of compound interest when you take no withdrawals. Your interest only gets interest (that’s the compounding part) if you don’t take it out.

Let’s take an example of a 5-year annuity account yielding 5.50% compound interest. Assuming a $100K investment and no withdrawals, the account is worth $105,500 after one year. Then $111,302.50 in year two, $117,424.13 in year three, $123,882.45 in year four, and after 5 full years, the total is $130,695.98.

After five years, your account had gained $30,695.98. Those are impressive gains.

And that’s the magic of compounding interest, your growth accelerates when the interest gains interest. Most fixed annuities offered today are compounding policies. They are great tax-deferred investments that work well for savings and growth.

But if you plan on taking regular withdrawals, it’s important to consider simple interest annuity accounts as well. There are times when the math favors these types of accounts.

Understanding Simple Interest Annuities

Simple interest annuity accounts do not compound your gains. You get a fixed, declared rate for your chosen term. It does not matter if you take withdrawals.

For example, let’s say you invest $100K into a 5-year fixed annuity offering a 6.00% simple interest rate. This would translate to $6,000 yearly interest gains – or $500 monthly. That’s perfect for those who want a regular income stream without touching their $100K principal.

But even if you do not withdraw your $6,000 interest, you would only receive $6,000 in interest in the following years. This means your policy credits $6,000 a year each year no matter what. After 5 years, you would have made a total of $30,000 (5 years at $6K a year). That’s simple interest. The math is easy and your gains are set from the start.

Simple and Compounding Interest Credits

Let me start by saying insurance companies aren’t dumb. They do the math too. That’s why you’ll see that Simple Interest annuity policies usually have higher yields than Compounding annuity accounts. Insurance companies offering both types will credit different rates for the same term.

If we use the two five-year examples above, you can see that a 5.50% compounding rate is nearly equal to a 6.00% simple rate. In fact, the compounding policy would yield a tiny bit more.

Also, know that these numbers are not pulled out of thin air. This is how the comparisons usually shake out. There is a spread between the two types of accounts that make them align in terms of overall interest credited.

Choosing One Fixed Annuity Type Over Another

Here’s where it gets interesting. Let’s say all other things being equal, you’re considering the two policies above. One five-year annuity plan that compounds at 5.50% — and one crediting 6.00% simple interest each year.

If you take no withdrawals, the compounding policy wins by approximately $700. Case closed.

But when regular withdrawals are taken, the compounding magic is eliminated. Let’s say you purchased the 5.50% policy and withdrew your interest regularly on a monthly or yearly basis. You would only receive $5,500 a year for a total of $27,500 after five years.

Woah, that’s a whopping $2,500 less than the $30,000 you’d get from the simple interest annuity! That’s why it’s essential to have an idea about your interest withdrawals before investing.

Who Offers Simple Interest Annuity Policies?

Currently, there are only a few companies offering simple interest MYGA (multi-year guaranteed annuity) accounts. Ibexis, Sentinel Life, and Atlantic Coast Life are three prominent players in this market. The latter two also offer compounding annuity policies as well.

Perhaps more will come along, but the three companies above are known for competitive rates. There are other important features to consider when investing in an annuity like AM Best rating, liquidity features, surrender charges, etc., That’s why it’s wise to talk with an expert before investing.

Working With An Annuity Broker

Generally, if you’re unsure about withdrawals, compounding policies are best. But you can see from the case study above that running the numbers is important. That’s where brokers add value. We can discuss the nuances of all types of policies so you are maximizing your gains and growth.

At Hyers & Associates, our independence allows us to work with all of the most competitive annuity providers available. We can help you compare your best annuity options. And you get our assistance at no cost. Contact us today!