Indexed Annuities
Indexed annuities (also called fixed indexed annuities or equity-indexed annuities) offer returns linked to a market index while providing principal protection. They combine features of both fixed and variable annuities.
How Indexed Annuities Work
An indexed annuity credits interest based on the performance of a market index (such as the S&P 500), subject to certain limits and conditions.
Key Characteristics
| Feature | Description |
|---|---|
| Index-linked returns | Interest tied to market index performance |
| Principal protection | Cannot lose principal due to market decline |
| Floor | Minimum credited rate (often 0%) |
| Cap | Maximum rate that can be credited |
| Participation rate | Percentage of index gain credited |
The Index Connection
Indexed annuities use various market indexes to determine interest credits:
Common Indexes Used
| Index | Description |
|---|---|
| S&P 500 | 500 large U.S. companies (most common) |
| Dow Jones Industrial Average | 30 large U.S. companies |
| NASDAQ-100 | 100 large non-financial companies |
| Russell 2000 | 2,000 small U.S. companies |
| MSCI EAFE | International developed markets |
Important Note
- Indexed annuities do NOT invest directly in the index
- The insurance company uses options and other strategies to provide index-linked returns
- The owner does not own any stocks or participate in dividends
Participation Rates
The participation rate determines what percentage of the index gain is credited to the annuity.
How Participation Rates Work
| Index Return | Participation Rate | Amount Credited |
|---|---|---|
| 10% | 80% | 8% |
| 15% | 80% | 12% |
| 20% | 80% | 16% |
Participation Rate Considerations
| Aspect | Description |
|---|---|
| Common range | 50% - 100% |
| Set by insurer | Can change at policy renewal |
| Higher is better | More of the gain credited to owner |
Cap Rates
The cap rate is the maximum interest rate that can be credited, regardless of index performance.
How Cap Rates Work
| Index Return | Cap Rate | Amount Credited |
|---|---|---|
| 5% | 8% | 5% (below cap) |
| 10% | 8% | 8% (capped) |
| 20% | 8% | 8% (capped) |
Cap Rate Considerations
| Aspect | Description |
|---|---|
| Common range | 3% - 10%+ |
| Set by insurer | Can change periodically |
| Impact | Limits upside but allows principal protection |
Exam Tip: Both participation rates and caps limit returns. If an index gains 15% and the contract has an 80% participation rate with a 10% cap, the credit is the LESSER of: 15% × 80% = 12% OR the 10% cap = 10% credited.
Floor Protection
The floor is the minimum interest rate guaranteed, protecting against losses when the index declines.
How Floor Protection Works
| Index Return | Floor | Amount Credited |
|---|---|---|
| -10% | 0% | 0% |
| -20% | 0% | 0% |
| -5% | 1% | 1% |
Floor Considerations
| Aspect | Description |
|---|---|
| Common floor | 0% (no loss, no gain) |
| Some contracts | Positive floor (e.g., 1%) |
| Principal protection | Even with 0% floor, principal is protected |
Interest Crediting Methods
Indexed annuities use various methods to calculate index gains:
Common Crediting Methods
| Method | Description |
|---|---|
| Annual point-to-point | Compares index value at start and end of year |
| Monthly point-to-point | Monthly gains/losses summed (often with caps on each month) |
| Monthly averaging | Average of monthly index values compared to starting point |
| Daily averaging | Average of daily values |
Annual Point-to-Point Example
| Date | S&P 500 Value | Calculation |
|---|---|---|
| January 1 | 4,000 | Starting value |
| December 31 | 4,400 | Ending value |
| Index gain | — | (4,400 - 4,000) / 4,000 = 10% |
If participation rate is 80% and cap is 12%:
- Participation: 10% × 80% = 8%
- Cap: 12%
- Credited: 8% (below cap)
Indexed Annuity Considerations
Advantages
| Advantage | Description |
|---|---|
| Principal protection | Cannot lose principal in market downturns |
| Upside potential | Can earn more than traditional fixed annuities |
| Floor guarantee | Minimum rate protects in down markets |
| Tax deferral | Earnings grow tax-deferred |
| Not a security | No securities license required to sell |
Disadvantages
| Disadvantage | Description |
|---|---|
| Limited upside | Caps and participation rates limit gains |
| Complexity | Many moving parts to understand |
| No dividends | Index return excludes dividends |
| Surrender charges | Often longer surrender periods |
| Rate changes | Participation rates and caps can change |
Indexed vs. Fixed vs. Variable
| Feature | Fixed | Indexed | Variable |
|---|---|---|---|
| Principal protection | Yes | Yes | No |
| Growth potential | Limited | Moderate | Highest |
| Investment risk | None | None | Owner bears risk |
| Complexity | Simple | Moderate | Complex |
| Securities license | No | No | Yes |
| Fees | Low | Moderate | Highest |
Suitability Considerations
Indexed Annuities May Be Suitable For:
| Profile | Why Indexed Annuities May Fit |
|---|---|
| Moderate risk tolerance | Wants some upside with downside protection |
| Concerned about market losses | Principal protection is appealing |
| Seeking better returns than fixed | Potential for higher credits |
| Long time horizon | Can benefit from market cycles |
Indexed Annuities May NOT Be Suitable For:
| Profile | Why Indexed Annuities May Not Fit |
|---|---|
| Seeking maximum growth | Caps limit upside |
| Short time horizon | Surrender charges limit access |
| Need simplicity | Complex features may confuse |
| Want dividends | Index credits exclude dividends |
Key Takeaways
- Indexed annuities link returns to a market index while protecting principal
- Participation rates determine what percentage of index gains are credited
- Cap rates set the maximum interest that can be credited
- Floor protection (often 0%) ensures no loss when the index declines
- Various crediting methods calculate index gains differently
- Not securities—no securities license required to sell
- Offer a middle ground between fixed and variable annuities
- Best for investors wanting growth potential with downside protection
An indexed annuity with a 70% participation rate and a 10% cap experiences an index gain of 12%. What interest rate is credited?
If the market index linked to an indexed annuity declines by 15%, and the contract has a 0% floor:
Unlike variable annuities, indexed annuities:
The annual point-to-point crediting method for indexed annuities:
16.1 Life Contingent Options
Chapter 16: Annuity Payout Options