If you are considering investing in a fixed indexed annuity, you should become familiar with a few terms. Almost all indexed annuities have internal moving parts referred to as spreads, caps, and participation rates. The fluctuations of these moving parts can significantly affect your annuity’s rate of return now and in the future.
Insurance companies will adjust their caps, spreads and participation rates each year and in doing so will either increase or decrease your potential rate of return. Thus, it’s a prudent measure to speak with an experienced agent about the renewal history of any annuity provider that are considering.
Insurance companies with a history of increasing spreads while lowering caps and participation rates in their policies should be viewed with a cautious eye.
Conversely, an annuity provider with a favorable track record of adjustments; one that consistently passes on more interest gains to their policyholders should immediately jump to the top of your list.
There are several factors that will affect the moving parts in your indexed annuity. Overall market volatility, the price of options contracts, portfolio performance of the given insurance company and the overall state of the economy are just a few macro examples.
However, some annuity providers tend to account for these future unknowns better than others. Even when their portfolios are under pressure, they still offer you the opportunity for better gains than many of their competitors.
Indexed annuity caps are simply a limit on the amount you can earn in a given time period – usually one year. Many indexed sub-accounts work with a cap no matter the crediting strategy or index you have chosen.
Insurance companies also offer indexed sub-accounts that are uncapped and have no limit to the returns on your investment. Uncapped sub-accounts usually have much larger spreads than those operating with a maximum cap. Yes, both spreads and caps can conspire to increase or decrease your interest gains.
For example, your annuity provider might offer a maximum limit (or cap) of 7% you can earn in an indexed account during the first contract year. If the cap on your earnings potential was lowered to 4% the following year, then your earnings potential has decreased significantly .
The most you could earn would now be 4% in this hypothetical example – as oppose to the 7% renewal you might have been expecting. You the investor would justifiably be upset with such a large decrease in future earnings power.
Indexed annuity spreads work much like caps when they are adjusted annually. The higher the spread, the lower the return will be. In essence, the spread comes off the top each year before any interest gains are credited to your investment principal.
If you were using an averaging index strategy and the spread for that sub-account was 2.5% for example, then only the gains above 2.5% would be credited to your invested amount at the end of a twelve month cycle.
However, if the spread increased to 5.0% upon renewal the following year, the account would need to make over 5.0% before any interest gains would be credited to your invested principal. In this example, the spread has increased by 100% and your potential return has decreased by 2.5%. Again, this type of increase is not favorable to you or your invested dollars.
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 (S&P 500 for example) is moving up.
Let’s say that you were offered an uncapped, point-to-point account with a 60% participation rate. If the chosen index increased by 10%, then you would receive 60% of the gain or a 6% rate of return on your money that year. If the participation rate renewed at 30% the following year, then you would only be credited with a 3% return on your money – all other factors being equal.
When the insurance company underwriting your annuity makes such a drastic change to the participation rate, which some do, your prospects for reasonable returns are reduced dramatically – even if the overall markets are performing well.
As you can see, fixed indexed annuities not only offer several crediting strategies, but they also have several moving parts such as caps, spreads, and participation rates.
While the crediting strategy you and your agent decide on will go a long way to determine your gains, the moving parts inside the chosen strategy will play just as an important role, if not more important, in determining your interest annuity growth.
It does not matter how well your index and crediting strategy are performing if your money can’t participate in a reasonable portion of the upside. That’s why it’s important to talk with an experienced agent about the renewal history of any insurance company you might do business with.
At Hyers and Associates, we work with hundreds of indexed annuities. We can help you choose a suitable indexed annuity account that fits your time frame and investment needs, but most importantly one that offers you the best opportunity for interest credits now and in the future. Contact us for more information today.