How participation rates affect the interest credited to indexed annuities

Indexed annuities credit 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. At the same time, they 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.

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.

One of the ways insurers limit the upside growth on indexed annuities is through participation rates.

A participation rate is a percentage of the index growth that the insurance company will credit to the annuity account value during a given period. Participation rates are usually found in point-to-point indexing strategies. The higher the participation rate, the more interest you will be credited with when the market index increases.

For example, an indexed annuity may have a participation rate of 80 percent. This means on a one year point-to-point strategy, the annuity will credit 80 percent of the index growth during the contract year. So if the index increased 10 percent during the contract year, the account value would only be credited 8 percent (10 x 80% = 8 percent). If the index increased 4 percent for the year, the account value would be credited with 3.2 percent interest (4 x 80% = 3.2 percent)

If the participation rate was 60 percent, then index growth of 10 percent would yield a 6 percent interest credit to the annuity’s account value (10 x 60% = 6 percent). An index that increases 4 percent during a contract year would result in an interest credit of 2.4 percent if a 60 percent participation rate was in force.

Insurance companies typically guarantee a participation rate for a specific term, be it for a year or the entire term of the annuity. Once that term has expired, the insurer can establish a new participation rate, though some contracts guarantee that the participation rate will never be set below a contractually set minimum.

Participation rates are often used in conjunction with caps and spreads. A cap is a ceiling on interest rate growth, which means your annuity’s account value can not increase more than the cap in any one period, regardless of how much the benchmark index increases.

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).

Assume an annuity has a 6 percent cap and an 80 percent participation rate. The benchmark index increases 15 percent during the contract year. The 80 percent participation rate limits the interest credited to 12 percent. But since this is above the 6 percent cap rate, the interest credited for the year will be 6 percent.

In some cases, cap rates are low enough that insurers have set their participation rates at 100 percent because the low cap will minimize the amount of interest earned. On the other hand, some insurers market uncapped strategies with unlimited interest potential by establishing a low participation rate, say 50 percent.