Like most annuity contracts, indexed annuities have certain
rules, restrictions, and expenses. Some insurance companies reserve the right
to change participation rates, cap rates, and other fees either annually or at
the start of each contract term. These types of changes could affect the
investment return. Based on the guarantees of the issuing company, it may be
possible to lose money with this type of investment. Therefore, it would be
prudent to review how the contract handles these issues before deciding whether
All of an IA's features should be clearly spelled out in
the prospectus or other sales literature, and if you purchase the IA, in your
contract as well.
annuity (IA) is a contract between you and an insurance company. You pay premiums
in a lump sum or periodically, and the issuer promises* to pay you some amount
in the future. The IA issuer also provides a minimum guaranteed* interest rate
on your premiums paid.
With an IA, the interest earnings are tied to the
performance of an equity index such as the S&P 500 or the Dow Jones
With an IA, your interest earnings may increase if the
market performs well, but if the market performs poorly, your principal is not
reduced by market losses. Indexed annuities are generally subject to a
lengthy surrender charge period. Most IAs pay a minimum guaranteed* interest
rate (e.g., 3%) on a percentage of premium (e.g., 87.5%). However, if the IA
doesn't earn interest greater than the minimum, cashing in the account prior to
the end of the surrender period may cause the investor to lose money.
Note, however, that any return, whether guaranteed or not,
is only as good as the insurance company that offers it. Both the IA's
principal and its earnings are entirely dependent on the insurer's ability to
meet its financial obligations.
Also, be aware that buyers of IAs are not directly invested
in the index or the equities comprising the index. The index is merely the
instrument used to measure the gain or loss in the market, and that measurement
is used to calculate the interest rate.
*Annuity guarantees are subject to the claims-paying
ability of the annuity issuer.
The first IAs that were introduced worked very simply; the
interest rate was determined by computing the difference between the value of
the index to which the annuity was linked on the annuity's issue date and the
value of the same index on the annuity's maturity date. If the difference was
negative (i.e., the market performed poorly and the value of
the index decreased), interest was calculated using the minimum interest rate.
If the difference was positive (i.e., the market performed well and the value
of the index increased), the interest rate used was a percentage of the
difference — but usually not the entire difference.
The participation rate determines how much of the gain in
an index will be imparted to your annuity. For example, if the difference
(i.e., gain) in the index is 7% and the participation rate is 90%, then the
interest rate is 6.3% (90% of 7%). Participation rates of 70% to 90% are
typical. Obviously, the higher the participation rate, the higher the potential
Participation rates are set and limited by the insurance company.
The indexing method is the approach used to measure the
change in an index. The original method, which measures index values at the
beginning and end of the term, is known as the point-to-point or European
method. The point-to-point method is the simplest approach, but it fails to
consider market fluctuations that occur in between the issue and maturity
dates. This can result in unsatisfactory returns if the market declines at the
end of the term.
Another approach, known as the high-water-mark or look-back
method, looks at the value of the index at certain points during the term, such
as annual anniversaries. The highest value of these points is then compared to
the date-of-issue value to determine any gain to be credited to the IA.
A third approach, the averaging method, also looks at the
value of the index at certain points during the annuity's term, then uses the
average value of these points to compute the difference from either the
date-of-issue value or the date-of-maturity value.
The fourth main indexing method is known as the reset or
ratcheting method. With this method, start-of-year values are compared to
end-of-year values for each year of the annuity's term. Decreases in the index
are ignored, and increases are locked in every year.
How interest is credited to an IA
With some IAs, no interest is credited until the end of the
term. With others, a percentage of the interest is vested or credited annually
or periodically, which gradually increases as the end of the term nears.
Further, some IAs pay simple interest while others pay compound interest.
These features are important not only because they affect the amount of your
return, but also because having interest vested or credited to your IA
periodically instead of at the end of the term increases the likelihood that
you'll receive at least some interest if the market thereafter declines.
Many IAs have surrender charges, which can be a percentage
of the amount withdrawn or a reduction in the interest rate. Further,
withdrawals from tax-deferred annuities before age 59½ may be subject to a 10%
Interest rate cap
Some IAs put an upper limit on the interest rate the
annuity will earn. Say, for example, that an IA has an interest rate cap of
6%. If the gain in the index is 7% and the participation rate is 90%, the
interest rate will be 6% — not 6.3%.
Some IAs charge an asset fee, also known as spread or
margin, which is a percentage that is deducted from the interest rate. The
asset fee may replace the participation rate or it may be added to it. For
example, if the gain in the index is 7%, the interest rate on an IA with an
asset fee of 2% will be 5%. If there is also a 90% participation rate, the
interest rate will be 4.5%.
Questions to ask about an IA
- What is the minimum guaranteed* interest rate?
- What is the participation rate?
- What is the indexing method? How does it work? Is there an
interest rate cap?
- Is there an asset fee/spread/margin? Is it in addition to
or instead of a participation rate?
- What is the term?
- When is interest credited or vested? Is interest
- What are the surrender charges? Are there penalties for
*Annuity guarantees are subject to the financial strength and claims-paying ability of the annuity issuer.