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 invested in the market or any index. The insurance company simply uses the index as a measuring stick for how much to credit to your contract.
Indexed annuities are more complex than other types of annuities because there are more factors involved in how interest is credited. Below are the six factors that will determine how much interest your indexed annuity will earn:
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.
The index performance
The insurance company will look at the value of the index or indices chosen on the first day of your contract and compare it with the value at a future date. The change in value, if positive, will be one of the determining factors of how much interest to credit. If the value decreases between periods, the annuity’s account value will credit zero for that period.
Insurers offer several formulas for crediting interest, often called strategies. Some use monthly index movements while others calculate an average movement over a given period. The most common strategy is a one-year point-to-point strategy. This strategy measures the one-year growth of an index and applies that percentage to the annuity’s account value. If the index declined in value during that one-year period, the annuity’s account value would not lose any principal.
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.
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.
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).