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New Money Rate

Under the new money rate (sometime referred to as the “banding approach,” or investment year method of crediting interest), the contributions made by all contract holders in any given period are banded together and credited with a rate of interest consistent with the actual yield that such funds obtained during the period. Thus, even though a company’s average return on all money may be only 5% in a given period, the contributions made by all participants during the current period may be credited with the 5.0% if the company was able to make new investments that, on average, returned in excess 5.0% interest. Moreover, the interest rate credited on those contributions should continue to earn 5.0% until the monies are reinvested. After reinvestment, the interest on these contributions will change and the rate credited to contributions banded in the following period could be higher or lower.

Under a trend of increasing interest, and assuming monies are reinvested every year, an investment in year 1 earns 5.0% (the new money rate for that year) and then earns 5.25% in the second year and 5.50% in the third year (See Illustration 3.5). An investment in year 2 earns 6.0% (the new money rate for that year) and then earns 6.00% in the second year and 6.25% in the third year. Finally, an investment in year 3 earns 7.0%.

Illustration 3.5

Illustrative Comparison of Increasing and Decreasing Portfolio Rates

Increasing Rates
 

Year

Year 1

Year 2

Year 3

One 5.00% 5.25% 5.50%
Two   6.00% 6.25%
Three     7.00%
       
Decreasing Rates
 
One 5.00% 4.50% 4.50%
Two   4.00% 4.00%
Three     3.00%

Note: The higher rates were used for the new money rate illustration. That is because the portfolio rate includes the return on investments made in earlier years at lower rates.


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