Fixed-Indexed Annuities
- Start
- different from other fixed annuities?
- Fixed-Indexed Annuity contract features?
- How do indexing methods differ?
- features of different indexing methods?
- tradeoffs of different indexing methods?
- impact of other equity-indexed annuity?
- cost to take money before end of the term?
- dividends included in the index?
- which Fixed-Indexed Annuity is best for me?
- What questions should I ask?
What are Fixed-Indexed Annuities?
A fixed-indexed annuity is a fixed annuity that earns interest or provides benefits that are linked to the performance of a stock index (for example S&P500, NASDAQ or Dow). The value of the index might be tied to a stock or other index. One of the most commonly used indices is the Standard and Poor's 500 Composite Stock Price Index. The value of any index varies from day to day and is not predictable. When you buy a Fixed-Indexed Annuity, you own an insurance contract. You are not buying shares of any stock or index.
How are they different from other fixed annuities?
A Fixed-Indexed Annuity is different from other fixed annuity contracts because of the way it credits interest to your annuity's value. Some fixed annuities only credit interest calculated at a rate set in the contract. Fixed-indexed annuities credit interest using a formula based on changes in the index to which the annuity is linked. The formula decides how the additional interest, if any, is calculated and credited; how much additional interest you get and when you get it depends on the features of your particular annuity. Your Fixed-Indexed Annuity, like other fixed annuities, also promise to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate even if the indexed-linked interest rate is lower. The value of your annuity also will not drop below a guaranteed minimum. For example, many single premium contracts guarantee the minimum value will never be less than 90 percent of the premium paid, plus at least 3% in annual interest (less any partial withdrawals). The minimum guaranteed value is the minimum amount available at the end of the term.
What are some Fixed-Indexed Annuity contract features?
Three features that have the greatest effect on the amount of additional interest that may be credited to a Fixed-Indexed Annuity are the indexing method, participation rate and cap rate. It is important to understand these features and how they work together. The following describes some other Fixed-Indexed Annuity features that affect the index linked formula.
Indexing method
The indexing method means the approach used to measure the amount of change, if any, in the index. Some of the most common indexing methods, which are explained more fully later on, include annual reset (ratcheting), high watermark, high water with look-back, short term point-to-point, long term point-to-point, monthly average, daily average and monthly cap.
Participation rate
The participation rate decides how much of the increase in the index will be used to calculate index - linked interest. For example, if the calculated change in the index is 10%, and the participation rate is 70%, the index linked interest rate for your annuity will be 7% (10%x.70%=7%). A company may set a different participation rate for newly issued annuities as often as each day. Therefore, the initial participation rate in your annuity will depend on when it is issued by the company. The company usually guarantees the participation rate for a specific period (from year to year or the entire period). When that period is over, the company sets a new participation rate for the next period. Some annuities guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified maximum.
Cap rate or cap
Some annuities may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the annuity will earn. In the example given above, if the annuity contract has a 7% cap rate, 7%, and not 8% could be credited. Not all annuities have a cap rate.
Floor on fixed-linked interest
The floor is the minimum index-linked interest rate that you will earn. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index-linked interest that you earn will be zero and not negative. As in the case of a cap, not all annuities have a stated floor on index-linked interest rates. But in all cases, your Fixed-Indexed Annuity and or fixed annuity will have a minimum guaranteed value.
Averaging
In some annuities, the average of an index's value is used rather than the actual value of the index on a specified date. The index averaging may occur at the beginning, the end, or throughout the entire term of the annuity.
Interest compounding
Some annuities pay simple interest during an index term. That means index-linked interest is added to your original premium amount, but does not compound during the term. Others pay compound interest during a term, which means that index-linked interest that has already been credited also earns interest in the future. In either case, however, the interest earned in one term is usually compounded in the next.
Margin/spread/administration fee
In some annuities, the index-linked interest rate is computed by subtracting a specific percentage from any calculated change in the index. This percentage might be instead of, or in addition to a participation rate. For example, if the calculated change in the index is 10%, your annuity might specify that 2.5% will be subtracted from the rate to determine the interest rate credited. In this example, the rate would be 7.5% (10%-2.5%=7.5%). In this example, the company subtracts the percentage only if the change in the index produces a positive interest rate.
Vesting
Some annuities credit none of the index-linked interest or only part of it, if you take out all of your money before the end of the term. The percentage that is vested, or credited, generally increases as the term comes closer to its end and is always 100% at the end of the term, unless free withdrawals or loans were taken during the contract.
How do the common indexing methods differ?
Annual reset
Index-linked interest, if any, is determined each year by comparing the index value at the end of the contract year with the index value at the start of the contract year. Interest is added to your annuity each year during the term. The previous year's ending point is the following year's beginning point. Your gains are locked in every year.
High watermark
The index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date you bought the annuity. The interest is based on the difference between the highest index value and the index value at the start of the term. Interest is added to your annuity at the end of the term.
Long term point to point
The index-linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term. Interest is added to your annuity at the end of the term.
Short term point to point
The index-linked interest, if any, is based on the difference between the index value at the start of the term and the value every year at each anniversary. With an annual reset these gains are locked in every year.
What are some of the features of different indexing methods?
Annual reset
Since the interest earned is "locked in" annually and the index value is "reset" at the end of each year, future decreases in the index will not affect the interest you have already earned. Therefore, your annuity using the annual reset method may credit more interest than annuities using other methods when the index fluctuates up and down often during the term. This design is more likely than others to give you access to index- linked interest before the term ends.
High-watermark
Since interest is calculated using the highest value of the index on a contract anniversary during the term, this design may credit higher interest than some other designs if the index reaches a high point early or in the middle of the term, then drops off at the end of the term.
Long term point to point
Since interest cannot be calculated before the end of the term, use of this design may permit a higher participation rate than annuities using other designs.
Short term point to point
Since the index-linked interest is potentially vested every year there is usually a lower participation rate or a cap.
What are some of the tradeoffs of different indexing methods?
Annual reset
Your annuity's participation rate may change each year and generally will be lower than that of other indexing methods. Also an annual reset design may use a cap or averaging to limit the total amount of interest you might earn each year.
High-watermark
Interest is not credited until the end of the term. In some annuities, if you surrender your annuity before the end of the term, you may not get index-linked interest for that term. In other annuities, you may receive index-linked interest, based on the highest anniversary value to date and the annuity's vesting schedule. Also, contracts with this design may have a lower participation rate that annuities using other designs or may use a cap to limit the total amount of interest you might earn.
Point to point
Since interest is not credited until the end of the term, typically six or seven years, you may not be able to get the index-linked interest until the end of the term.
What is the impact of some other equity-indexed annuity product features?
Cap on interest earned
While a cap limits the amount of interest you might earn each year, annuities with this feature may have other product features you want, such as annual interest crediting or the ability to take partial withdrawals. Also, annuities that have a cap may have a higher participation rate.
Averaging
Averaging at the beginning of a term protects you from buying your annuity at a high point, which would reduce the amount of interest you might earn. Averaging at the end of the term protects you against severe declines in the index and losing index-linked interest as a result. On the other hand, averaging may reduce the amount of index-linked interest you earn when the index rises either near the start or at the end of the term.
Participation rate
The participation rate may vary greatly from one annuity to another and from time to time within a particular annuity. Therefore, it is important for you to know how your annuity's participation rate works with the indexing method. A high participation rate may be offset by other features, such as simple interest, averaging, or a point-to-point indexing method. On the other hand, an insurance company may offset a lower participation rate by also offering a feature such as an annual reset indexing method.
Interest compounding
It is important for you to know whether your annuity pays a compound or simple interest during a term. While you may earn less from an annuity that pays simple interest, it may have other features you want, such as a higher participation rate.
What will it cost me to take my money out before the end of the term?
In addition to the information discussed about surrender and withdrawal charges and free withdrawals, there are additional considerations for equity-indexed annuities. Some annuities credit none of the indexed-linked interest or only part of it if you take out the money before the end of the term. The percentage that is vested, or credited, generally increases as the term comes closer to its end and is always 100% at the end of the term.
Are dividends included in the index?
Depending on the index used, stock dividends may or may not be included in the index's value. For example, the S&P500 is a stock price index and only considers the prices of stocks. It does not recognize any dividends paid on those stocks.
How do I know which Fixed-Indexed Annuity is best for me?
As with any other insurance product, you must carefully consider your own personal situation and how you feel about the choices available. No single annuity design may have all the features you want. It is important to understand the features and tradeoffs available so you can choose the annuity that is right for you. Keep in mind that it may be misleading to compare one annuity to another unless you compare all the other features of each annuity. You must decide for yourself what combination of features makes the most sense for you. Also remember that it is not possible to predict the future behavior of an index.
What questions should I ask my agent or company?
- How long is the term?
- What is the minimum guaranteed interest rate?
- What is the participation rate? For how long is it guaranteed?
- Is there a minimum participation rate?
- Does the contract have an interest rate cap? What is it?
- Does the contract have an interest rate floor? What is it?
- Is interest rate averaging used? How does it work?
- Is interest compounded during a term?
- Are there any fees in the contract?
- What indexing method is used?
- What are the surrender charges or penalties if I want to end my contract early?
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