How do indexed annuities work?
Fixed indexed annuities are insurance products that provide both protection from downside market risk and growth potential by offering a guaranteed interest rate for a set period, as well as the opportunity for additional interest credits based in part on the performance of a market index.
Retirement savings held in an FIA are not invested directly in the markets. Instead, interest credits fluctuate based in part on the performance of one or more reference indices. When a particular index is up, the annuity's value may increase: Interest credits are applied to the portion of the annuity's accumulated value that is allocated to that index's crediting strategy. When the market is down, the interest rate declines to zero, but the value of the annuity holder's initial premium—as well as prior credited interest—remains intact. Thus, retirement savings are protected from market downturns.
While all FIAs share the same overall characteristics—the potential to benefit from market growth without taking on the risks of direct market participation—the details may vary. Indexed annuities differ in terms of which benchmark indices they track, how often they calculate changes in the indices, how they determine crediting strategies, and what additional benefits they may offer.
Here are some key factors that impact how FIAs function:
- What underlying indices does the annuity track? While about half of all FIAs use the S&P 500 as their benchmark, other FIAs track hybrid or alternative indices designed to pursue specific strategies, such as noncorrelation to the major equity indices and/or targeting specialized groupings of asset classes.
- How does the annuity calculate index returns? FIAs may calculate changes in the index from the start and end of a specific period, such as a month or year. This is called a point-to-point strategy. In addition, the tracked return may include or exclude dividends (total return) or returns in excess of the risk-free rate (excess returns).
- What is the annuity's crediting strategy? An FIA's interest credits typically are based on a formula such as a cap (an upper limit on return) or participation rate (the percentage of an index's return credited to the annuity), or a percentage-based fee such as a spread. For example, if the benchmark index returns 8 percent, an FIA with a 4 percent cap will receive an interest credit of 4 percent; an FIA with a 90 percent participation rate will receive an interest credit of 7.2 percent; and an FIA with a 2 percent spread will receive 6 percent
- Does the index offer additional riders? Clients may opt to add features to their annuity at an additional cost. FIAs may offer such riders as guaranteed lifetime income, liquidity options, a premium bonus or death benefits.
FIAs in action
To see how these formulas translate into returns for annuity holders, consider a hypothetical FIA that tracks the S&P 500 as its benchmark and uses a participation rate of 50 percent and a one-year point-to-point strategy:
1-Year No Cap Point-to-Point Index Strategy Interest Calculation, Hypothetical Example
Beginning Index Value = 2,300
Ending Index Value = 2,500
Participation Rate = 50%
Percentage change in the Index = (2,500 – 2,300) / 2,300 = 8.7%
Interest credited = 8.7% x 50% = 4.35%
In this hypothetical example, the interest credit at the end of one year is 4.35%.
- Chart Source: 68005 1 yr NoCapPTPIndexStrategy document