Fixed Indexed Annuity Features
Common Attributes of Fixed Indexed Annuities
All fixed indexed annuities share several common features, such as an indexed linked account, a crediting method, and a guaranteed rate. This article will explain and breakdown each of the main fixed indexed annuity features.
Indexed Linked Account
Fixed indexed annuities track the performance of a stock market to determine the interest rate of the policy. The S&P 500 and the NASDAQ 100 are the most commonly used indices, however other choices are often available. These indices consist of a pool of stocks chosen for market size, liquidity and industry grouping, among other factors. Designed as leading indicators of U.S. equities, they reflect the risk & return characteristics of the large-cap sector.
It is important to note that indexed annuity funds do not purchase shares or equities directly. Instead, the insurance company simply credits your account based off the index performance each year. By contrast, you stand to lose principal with a variable annuity that uses your capital to purchase individual stocks and mutual fund shares.
Each Fixed Indexed Annuity will calculate or credit the rate of return differently. However, they will all have a mechanism in place to protect against any downside risk, and also limit the upside returns. The three most common used to limit upside are the participation rate, a cap, and a spread.
The participation rate determines the percentage of an index’s growth used to credited the annuity. It will usually range anywhere from 70%-100%.
Example: Lets assume a $100,000 fixed indexed annuity linked to the S&P 500 has a 70% participation rate:
If the S&P 500 experiences 10% growth for the year, the account is credited with 70% of that 10% growth. This results in a 7% interest rate for the year that the annuity will receive. The account value would now be $107,000.
A cap sets a maximum rate of return for a fixed indexed annuity in a given year. Caps typically range anywhere from 3% to 15%.
Example: Assuming a $100,000 fixed indexed annuity with a cap of 10%.
If the S&P were to go up by 14% in a given year, the annuity would be credited up to the 10% cap. This would credit the account with the maximum return of $10,000 for the year.
A spread subtracts a set percentage from the index gains each year. A typical spread is around 2%-5%.
Example: Assuming a $100,000 FIA with a 3% spread.
If the S&P were to have a positive year with an 8% return, an annuity with a 3% spread would deduct 3% from the 8% total return, giving the FIA a rate of return of 5% for the year.
Which crediting method is best?
The “best” crediting method for an owner of a fixed indexed annuity depends on the year to year performance of the index. For the years that have a low or moderate positive growth rate, say 5%, a cap would be best because the policy owner receives the entire 5% return. However, for the years where the S&P performs especially well, a spread or participation rate would outperform a cap.
Minimum Guaranteed Rate
The minimum guarantee rate on a fixed indexed annuity is essentially a safety net for the unlikely event that the linked-index is down for the entire length of the policy.
The insurance company will set a minimum guarantee of around 1%-3% annually. It will then compare the minimum guaranteed rate to the indexed linked rate and credit the policy with the higher of the two.
It is important to keep in mind that this comparison is done on the entire length of the policy, and not on a year to year basis.