Indexed annuity, sometimes referred to as fixed indexed annuities, or FIAs, provide the potential to earn higher returns than those offered by traditional fixed annuities but without risking principal to market losses.

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 use a variety of market indices. Some contract will even offer you choices on what indices you want your contract to be based upon. The most common index used as a benchmark is the Standard & Poor’s 500 (S&P 500), which is a widely used index to measure the U.S. stock market. Other options include the Russell 2000, the Wilshire 5000 and some international market indices.

Insurers offer several formulas for crediting interest, often called strategies. The strategy(s) you choose can significantly impact how much interest is credited to your annuity. That’s why you should carefully consider your options.

Also keep in mind that no single crediting method is best in all situations. In some market conditions, one crediting method may result in more interest than others.

Basics of the monthly sum strategy

One type of strategy is the monthly sum strategy. The method of crediting interest adds monthly percentage movements of a market index over a year to determine the amount of interest credited to the annuity contract. Here’s how this type of strategy works:

Each month, the index value is compared to the prior month’s value, and the percentage change is calculated. Typically, a monthly increase is subject to a tax, but monthly decreases generally are not. At the end of the year, the 12 percentage movements are added together.

If the sum is positive, the annuity will be credited with that amount of interest. If the sum is negative, the contract will credit zero interest; the annuity’s account value won’t decrease in value due to the decline in the index, but the contract will not earn interest for that period.

For example, say you purchased an indexed annuity with a contract start date of August 1, 2015. The annuity’s indexed crediting strategy uses a monthly sum based on the Standard & Poor’s 500 index, with monthly increases capped at 2 percent.

On the first day of the contract, the S&P 500 opened at 1972.18. One month later, the index had fallen to 1920.03, for a percentage decline of -2.64 percent. Between the second and third month, the index increases 8.30 percent, but since there is a 2 percent cap on monthly increases, the sum for that period will be 2 percent, not 8.3 percent.

The monthly percent movements for the S&P 500 for the entire contract year were as followed:

Month 1: -2.64

Month 2: 2.00

Month 3: 0.00

Month 4: -1.75

Month 5: -5.07

Month 6: -0.41

Month 7: 2.00

Month 8: 0.27

Month 9: 1.53

Month 10: 0.10

Month 11: 2.00

Month 12: -0.14

The 12 percentages are added together, which results in a value of -2.11. Since the total is negative, the annuity will be credited with 0 percent interest for the year.

A monthly sum strategy tends to be the most sensitive strategy to market volatility, but it also will typically provide the most potential interest growth than other strategies.

An explanation 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.