Index annuities can be the best of both worlds if they have favorable terms. A good index annuity has a high participation rate, high guaranteed minimum rate, low administration fees, high rate cap, and an annual reset provision. When reviewing contracts, weigh all of these factors holistically, as each insurance company strikes a unique balance.
Each insurance company and annuity carrier offer their own unique products, and will often have several different indexed annuities to choose from with multiple options.
The percentage of growth you receive on positive years.
The minimum rate that you receive during the length of the contract.
The maximum percentage the account value and increase or decrease in a year.
Determines how the index gains are calculated and credited to the account.
What to look for when choosing an indexed annuity.
These factors work towards maximizing returns while reducing risk.
Generally, though, there are trade-offs: the longer the commitment, the less flexibility, the higher the rate. Look for contracts with the highest rate and the least flexibility you can tolerate.
The participation rate is the percentage of growth you receive on positive years. The higher the participation rate, the more you gain from an index’s growth. Small variations in this factor can significantly impact returns, so be sure to find the highest possible. Typical participation rates range from 50%-90% depending on other factors.
Let's see how participation rate affects returns. If we compare two identical S & P 500 linked annuities, except annuity A has a 50% participation rate while annuity B has 90%. If we invested $100,000 in both and the S & P 500 rose 14%, account A would have $107,000 while account B would have $112,600. A $5,600 or 40% difference.
Because most index annuity earnings stem from moderately positive annual growth, getting a bigger piece of the pie via high participation rate is priority one.
Every index annuity features a minimum rate that you receive during poor-performance years. The minimum rate serves two roles: 1) to protect against potentially catastrophic loss, and 2) to generate moderate growth. Function #1 is far more important and comes for "free" with any index annuity contract. Function #2 is a nicety, but shouldn't be prioritized over a participation rate.
A typically index annuity contract will stipulate a 1-3% minimum rate. Obviously look for the highest rate you can find, but this factor isn't nearly as significant finding a high participation rate. Even a 1% minimum rates serves the purpose of preserving capital.
Let's take a look at how an index annuity protects capital during down years. Suppose we invest in an S & P 500 linked annuity with a 50% participation rate. Suddenly the market turns sour and the S & P 500 drops 40% over the next year. Do you lose 20% of your investment? No! The minimum rate guarantees that even during the worst market crash you’ll still be earning money. If our contract stipulated a 2% guarantee, that's how much we'd earn this year.
Most indexed annuities include a yield or rate cap that sets the limit the amount that's credited to the accumulation account. For example, a 7% rate cap limits the credited yield to 7% no matter how much the stock index gained. Rate caps typically range from a high of 15% to as low as 4% and are subject to change.
In example, if the index had a return of 10% gain in a given year, the annuity would be credited those gains up to the 7% cap, but nothing beyond that.
There are also Cap Rates that protect the downsides of the market as well. These rates typically range between 0% (meaning the account value never goes down in negative years) to 10%.
When looking for the "best" indexed annuity, you'll want to find a product with the highest upside cap, and the lowest downside cap.
The crediting method of an indexed annuity determines how interest is calculated for a fixed index annuity. The crediting method chosen measures the amount of interest that the annuity holder can receive over a specific time period.
Most contacts include a combination of caps (maximum interest allowed), participation rates (fraction of interest credited to the contract) and spreads. These limit the upside potential of increases in index value.
Some of the crediting methods used by insurance companies include:
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