Is an Indexed Annuity a Good Idea?

Features of Indexed Annuities

As a result of the way in which interest is credited to equity indexed annuities, these products are characterized by a number of unique features. For example, most include some provision that limits the amount of indexed interest that will be credited to the contract. These limits take the form of participation rates, spreads (or margin rates), and caps.

Participation Rate

The participation rate is the amount or level of the index increase that will be credited to the contract. For example, if the participation rate is 80 percent and the index to which the contract is tied increased by 11 percent over the crediting period, then the contract will be credited with 8.8 percent interest (.80 × .11 = .088). If the participation rate is 70 percent and the index to which the contract is tied increased by 11 percent over the crediting period, then the contract will be credited with 7.7 percent interest (.70 × .11 = .077).

Indexed annuity participation rates vary widely from insurer to insurer and from product to product. Some may be as low as 50 percent; others may be as high as 90 percent or 100 percent. Products with lower participation rates may feature additional benefits that are not included on products that apply higher participation rates. Conversely, products that have longer terms may carry higher participation rates than those with shorter terms.

Margin

As an alternative to—or in addition to—a participation rate, some indexed annuity issuers use a margin (or spread) to determine the interest rate that will be credited to their contracts. A margin is a stated percentage deducted from the percentage change in the index level before that percentage is applied as an interest rate to the annuity funds. Thus, a margin is subtracted from the index yield, and the remainder is the credited interest rate. For example, if the index to which the contract is tied increased by 8 percent and the margin is set at 5 percent, the interest rate that will be applied to the annuity for that specific crediting period will be 3 percent (.08 - .05 = .03).

Cap

In addition to a participation rate or margin, indexed annuities usually impose a cap, which is the maximum amount of interest that will be credited during any one interest crediting period. An 8 percent cap, for instance, limits the amount of interest credited to the contract in any interest crediting period to 8 percent regardless of the performance of the underlying index and regardless of the participation or margin rates.

Floor

Most indexed annuities contain provisions that prevent any negative index return from affecting the contract’s previously credited values. This is known as the floor—the minimum amount of indexed-linked interest that is to be credited to a contract during any crediting period. With most indexed annuities, the floor is zero. In other words, if the index to which an annuity is tied were to decrease over the crediting period, the amount of indexed interest that would be credited to the contract would be zero—no indexed interest would be credited. As a result, a decline in the index would not equate to negative interest crediting.

Example

For example, assume that an indexed annuity provides for annual interest crediting, an 80 percent participation rate, and a zero percent floor. During the first two contract years, the index to which the annuity is tied yields a positive return; the third year, the index return is negative; in years four and five, the returns are again positive. The following illustrates the amount of interest that would be credited to the contract in each of these five years:

The negative index return in Year 3 does not generate negative interest crediting; instead, the zero percent floor results in no index interest credited in Year 3, and the annuity’s value does not decline.

An indexed annuity’s floor should not be confused with the product’s minimum guaranteed rate of return. The floor represents the minimum rate of indexed interest that will be credited to the contract during any crediting period; the minimum guaranteed rate of return is the rate that will be applied to the contract at the end of the contract’s crediting term if the index interest accumulations are less than the minimum guaranteed.

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