Fixed-indexed annuities are rising in popularity. I’ve seen that in the financial news, and I’ve seen that firsthand with how many people contact me asking about them. The timing is a bit surprising because the stock market has been notoriously volatile for the past few months. Despite that, people generally view the stock market as the best option for generating income — even if it is the riskiest. That may be why fixed-indexed annuities are such an appealing option.
Fixed-indexed annuities offer the potential for competitive interest rates based on the positive performance of an external index, plus a guarantee of a minimum interest rate, which usually ranges from 0-3% depending on the product. These fixed-indexed annuities are products that offer both competitive interest growth potential and guarantees to your principal.
How the Interest on a Fixed-Indexed Annuity Is Calculated
Fixed-indexed annuities are called that because their interest potential is based, to an extent, on an external market index. There are indexes all over the world, but the most commonly known to U.S. investors are:
- Dow Jones Industrial Index: This covers 30 major industrial U.S. companies.
- S&P 500: This covers 500 major U.S. companies in various industries.
- DAX: This covers 30 major German companies.
- Nikkei 225: This is based on Japanese companies.
- Hang Seng Index: This covers the Hong Kong stock exchange.
One of the most commonly used indexes for fixed-indexed annuities is the S&P 500. The S&P 500 is a relatively diverse index. This allows insurance companies to offer interest credits to annuity holders based on these indexes. If the annuity holder selects the S&P 500 index allocation option, and that index performs strongly as of the annuity’s annual contract anniversary, the annuity may receive interest credits that are tied to the index — of course, with some limitations.
Provisions That Limit Fixed-Indexed Annuities’ Interest Potential
Fixed-indexed annuities allow the owner to take advantage of a guaranteed minimum interest rate with the potential to earn more based on the performance of the index. If the index loses value, you won’t lose money due to market risk and you have the opportunity to earn additional interest without having to make up for any prior losses in the index first. How much you’ll see of an interest rate will depend on several underlying factors in your annuity contract.
- Guaranteed minimum return. This is the least amount of annual interest your annuity will earn. On average, the guaranteed minimum rate of return is anywhere from 0-3% This is the bare minimum your annuity will earn provided you don’t cash it out and have to pay surrender fees, which could result in a loss of principal and previously earned interest.
- Interest rate caps. This is the upper limit of interest you can earn on an annuity. This limits how much the insurance company will credit to your annuity in interest based on the performance of the external index. So even if the index makes a 10% gain as of your contract anniversary, but you’re capped at 8%, 8% is the maximum interest rate you’ll get.
- Participation rate. This is another upper cap, which determines how much you’re allowed to participate in the upside of the index via interest credits. This is represented as a percentage, such as, for example, 80%. In this case, if the market index option saw a 10% gain on your contract anniversary, you’d participate in 80% of this — and earn 8% interest.
- Spread/asset fees. The spread or asset fees are usually presented as an interest rate that’s subtracted from the total gross interest rate. So if you’re set to receive a 7% interest credit due to the index performance, and your insurance company’s spread or asset fee is 2%, you’d see a 5% net interest credit.
Some annuity contracts will use a combination of methods to reduce the overall interest credited on a fixed-indexed annuity. They do this to help better balance costs. After all, when the index sees a loss, which isn’t uncommon, you won’t lose any money due to that and will continue to receive your guaranteed interest rate — which could be 0% in some cases, but at least you do not lose principal due to market loss. Despite all of this, these annuities shouldn’t be viewed as risk-free.
The Limitations of Fixed-Indexed Annuities
When it comes to interest potential, the fixed-indexed annuity usually falls somewhere between a fixed annuity and a variable annuity. It offers the guarantees that are similar to a fixed annuity, but with the potential for a higher interest rate. Despite that, it’s not foolproof. Guaranteed minimum interest rates can be quite low — so low they generally will not keep up with inflation. These annuities are dependent on positive performance of a market index to help address this.
Another drawback is that surrender periods are typically longer for fixed-indexed annuities. This means that if you want to get out of the annuity earlier, you’ll likely have to pay a surrender charge, which can result in a loss to your principal as well as any previously earned interest. You’ll be locked into that annuity for a longer period, meaning it could be as long as 10 to 12 years before you can take the money out without incurring a loss due to surrender charges,
When considering a fixed-indexed annuity, talking with a financial professional in Retirement HQ’s network can help you determine if it is appropriate for your situation. Contact one of our insurance agents for more information about these unique annuities.