How insurers can guarantee principal on FIAs.
Indexed annuities are touted as offering the opportunity to participate in market gains without the risk of losing your principal due to market losses that come with regular investing. Because indexed annuities offer this best of both worlds, many potential annuity buyers wonder if they are too good to be true.
How indexed annuities work
An indexed annuity (sometimes referred to as a fixed indexed annuity or FIA) is a contract with an insurance company. You make a single purchase payment or a series of payments to the company. The annuity can provide a lifetime stream of income or payments over a contractually defined term.
What sets indexed annuities apart from other types of annuities is the method of crediting interest. They earn interest based on the movement of a market index, giving them the ability to grow higher in value than fixed annuities that charge a flat rate of interest. However, you are not actually invested in the market or in any index. The insurance company simply uses the index as a measuring stick for how much to credit to your contract.
Indexed annuities also have a provision whereby the contract cannot lose value based on how the corresponding index performs. If the index loses 5 percent, 15 percent or even 75 percent in a given period, the annuity’s account value remains steady. Zero interest is the worst your contract can return in a given period. This makes it a safer alternative to a variable annuity.
So how can an insurance company guarantee no market losses while paying out a rate of interest that is based at least in part on the upward movement of the market without being invested in the market?
How buying options protects your investment
There are two ways this occurs. First, the insurance company invests the premium you use to buy your annuity, standard procedure for all annuity purchases. Most of it is used to purchase bonds. This way, the insurance company can count on a set rate of interest, regardless of how the market performs.
What makes indexed annuities different is that they use a small portion of your premium to buy what are called options. An option allows an investor to profit from the direction of the market as opposed to actualizing being in the market. Buying an option isn’t like owning a stock or commodity. Instead, it’s making a bet on the direction of the market’s movement.
There are two basic types of options: calls and puts. Call options enable investors to make money when the market goes up. With a put, you profit when the market falls.
Using that small portion of your indexed annuity premium, the insurer buys call options on the index the annuity is tracking, such as the S&P 500. If that index goes up, the insurance company profits from those options, which becomes part of the index interest credited to your annuity contract.
If the index declines in value, the insurer loses the money it invested in the call options. But it recoups those losses with the income it generated through its investment in its bond portfolio. Essentially, the insurance company’s bond portfolio provides the downside protection to your indexed annuity, while the call options provide the upside growth potential.
Caps and spreads
The second way indexed annuities can provide upside potential with no downside risk is through the use of caps and spreads.
Because indexed annuities do not lose principal, there has to be a limit on their upside. As an indexed annuity holder, you’re essentially trading unlimited interest rate growth for the protection against negative returns.
Insurers have two methods of limiting an indexed annuity’s upside: caps and spreads.
A cap is a ceiling on interest rate growth. A typical cap might be 8 percent. That means your annuity’s account value can not increase more than 8 percent in any one period, regardless of how much the benchmark index increases. If the index increases 5 percent, your account value will increase 5 percent. If the index climbs 12 percent, the account value will be limited to 8 percent.
A spread, on the other hand, acts more like a floor. If your annuity has a 5 percent spread, your account value will increase by whatever percentage above 5 percent the corresponding index goes up. If the index increases 7 percent, your account value will grow 2 percent (7 – 5). If the index climbs 15 percent, your account value will earn 10 percent. But if the index only increases 3 percent, your account value will earn nothing for that period.