Fixed Index Annuities Provide An Interest Rate – How Is That Calculated?
Fixed indexed annuities (or FIAs) provide an interest rate to their annuitants. In a similar vein, fixed annuities also pay interest. The interest, in that case, is a set rate for the term of the contract. FIAs, however, have a much more complicated interest rate calculation.
There are two main things that impact how an FIA interest rate is calculated. First, there’s the indexing method, and second, there’s the participation rate. Let’s take a closer look at what these terms mean.
When an FIA provides an interest rate, its issuer uses an indexing method to calculate it. This index may mimic the market, but an FIA isn’t dependent on the market. No matter what the market does, your principal will still be protected. This is part of the benefit of using an FIA.
There are three types of indexing methods used in FIA calculations:
Point to Point
First, insurance companies define a certain time period for the point-to-point guideline. As an example, one every month, or every year. Next, we look at the starting value of your index. Lastly, the difference between starting value and the point-to-point value is noted. If the change goes up past a certain percentage, your interest rate may increase for that period. If it goes down, you’ll still maintain your principal balance. You may also receive a certain minimum interest rate, depending on the terms of your annuity contract.
With this method, the FIA still provides a rate looking across a period of time. However, it doesn’t measure each change. Instead, the high-water mark method finds the highest point of the index within a set timeframe. It then calculates the difference between this and the annuity’s index at the start of that timeframe. The interest provided is based on the difference.
As the name suggests, this method is more simple. You take the index value at the end of the contract year and compare it to the index value at the beginning of that year.
Indexing methods determine which data points of the index are used for annuity interest rates. Participation rates, on the other hand, tell you how much influence the index will have on the interest. the insurance company sets your participation rate once you find your annuity. Usually, for a period of time, this rate cannot change. Additionally, the details of your participation rate are specified in your contract. For example, the participation rate may change after a certain period of time. Or, the rate might be set to never go below a certain percentage.
As an example of participation rate in action: A participation rate is set to 75% of the S&P 500. This doesn’t mean that your principal value is at risk, but it means that the index for your annuity is the S&P 500. If the S&P 500 goes up by 10%, your annuity would participate in 75% of this increase. Therefore, for that term, you’d gain 7.5% interest.
Other Factors to Consider
In addition to indexing method and participation rate, there are other important annuity terms to learn. Including:
Floor/Minimum Interest Rate
This defines the lowest rate you’ll ever receive, for the term within the contract.
Instead of exacting point-to-point index values, averaging looks at the, well, average values of the index over a certain period.
Some FIAs, but not all, have a cap rate. This is the maximum interest that an annuity can receive.
This is a predetermined percentage of growth, set aside before calculating the annuity’s interest rate.
Do you have questions about FIAs? Cornerstone Wealth and Tax Advisory is here to help. Contact us for a no-obligation meeting and discussion, or attend one of our dinner seminars, to learn more.