An indexed annuity is a type of annuity contract that pays an interest rate based on the performance of a specified market index, such as the S&P 500. Unlike fixed annuities, which provide a fixed interest rate, and variable annuities that depend on a portfolio of securities selected by the annuity owner, indexed annuities offer a blend of stability and potential growth. They are sometimes called equity-indexed or fixed-indexed annuities.
Key Takeaways
- An indexed annuity pays an interest rate based on a particular market index, such as the S&P 500.
- Indexed annuities allow buyers to potentially benefit when financial markets perform well, unlike fixed annuities that offer a set interest rate regardless of market conditions.
- Certain contract provisions can limit the potential upside to only a portion of the market’s rise.
How Indexed Annuities Work
Indexed annuities offer their owners, or annuitants, the chance to earn higher yields than fixed annuities when financial markets perform well while also providing some protection against market declines.
The interest rate on an indexed annuity is calculated based on the year-over-year gain in the index or its average monthly gain over a 12-month period. However, the annuitant won’t necessarily reap the full benefit of any rise in the index. This is because indexed annuities often set limits on the potential gain, commonly referred to as the “participation rate”.
The participation rate can range from as high as 100%, meaning the account is credited with all of the gain, to as low as 25%. Most indexed annuities typically offer a participation rate between 80% and 90% during the early years of the contract. For example, if the stock index gained 15%, an 80% participation rate would translate to a credited yield of 12%. Many indexed annuities offer a high participation rate for the first year or two, after which the rate may adjust downward.
Yields and Rate Caps
Most indexed annuity contracts also include a yield or rate cap that can further limit the amount credited to the accumulation account. For example, a 7% rate cap limits the credited yield to 7% regardless of how much the stock index gains. Rate caps typically range from a high of 15% to as low as 4% and are subject to change.
Using the earlier example, a 15% gain would be reduced to 12% by an 80% participation rate, and further reduced to 7% if the annuity contract specifies a 7% rate cap. When shopping for an indexed annuity, it’s crucial to ask about its participation rate and rate caps, as both can reduce your potential gains from any market rise.
In times when the stock index declines, the insurance company credits the account with a minimum rate of return. A typical minimum rate guarantee is about 2%, but it can range from as low as 0% to as high as 3%.
Adjusted Values
At specific intervals, the insurer will adjust the value of the account to include any gain that occurred during that time frame. The principal, which the insurer guarantees, never declines in value unless the account owner takes a withdrawal. Insurers use several methods to adjust the account’s value, such as a year-over-year reset or a point-to-point reset, which incorporates two or more years’ worth of returns.
As with other types of annuities, the owner can begin receiving regular income by annuitizing the contract and directing the insurer to start the payout phase.
Related Terms: Fixed Annuity, Variable Annuity, Annuity Contract, Participation Rate, Rate Cap.
