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Understanding caps, spreads, and participation rates on fixed indexed annuities

Just about all financial vehicles have pros and cons. For instance, stocks and mutual funds that have the potential for high growth will typically also subject you to a lot of risk. On the other hand, savings accounts and fixed products like government bonds are “protected” in downward moving markets, but the rate you earn on these is usually minuscule.

One financial vehicle that appears to have a “best of all worlds” concept is the fixed indexed annuity. That’s because your account value remains safe, and you also have the potential for higher growth than you would in a regular fixed annuity.

But there is a catch!

How Growth is Limited on a Fixed Indexed Annuity

As you approach retirement, safe money becomes important. But oftentimes, so does growth, which can help to build up your “base” from which to draw income. At first glance, fixed indexed annuities, or FIAs, seem like they can address all of these issues, along with providing you with a steady stream of income in the future.

But wait, there’s more!

Before you purchase one of these annuities sight unseen, you really need to know what to expect, because the “opportunity” for growth and actual growth are two entirely different things!

First, what makes a fixed indexed annuity different from a regular fixed annuity is the way that the return is calculated. In this case, the annuity tracks one or more market indexes, such as the S&P 500 or DJIA.

If the index performs poorly during a given contract year, there is no loss in the account. Rather, the funds in the annuity are simply credited with a guaranteed minimum “floor” (which is oftentimes in the range of 0% to 2%).

On the upside, though, if the underlying index(es) performs well, a positive return is credited to the annuity. But this growth is often limited in a fixed indexed annuity by a cap, spread, and/or participation rate.

How exactly do these fixed indexed annuity crediting methods work?

Cap

A cap rate is a maximum return that will be credited to the annuity if the underlying index(es) performs well. In this case, if the annuity imposes a 7% cap, and the index returns 10% for a given month or year, the funds in the account will receive a return of 7%.

Alternatively, if the underlying index returns 3% during a contract month or year, the annuity is only credited with 3% for that period. As with other annuities, though, the growth that takes place in a fixed indexed annuity is tax-deferred, meaning that no tax is due on the gain until the time of withdrawal.

Participation Rate

If there is a participation rate on the annuity, this will determine how much of the underlying index(es) increase will be used in computing the return. As an example, if the annuity’s participation rate is 80%, then the return credited to the annuity will be 80% of the return on the index. Therefore, with a return on the index of 5%, and a participation rate of 80%, the annuity’s return would be 4%. That is because 80% of 5% is 4%.

Spread

In some FIAs, the return will be based on a spread. This means that the interest credited will be determined by subtracting a certain percentage from any gain in the underlying market index. For instance, if the spread on a fixed indexed annuity is 4%, and there is an increase in the index of 10% for a crediting period, then the annuity will gain 6%. (10% minus 4% is 6%).

It is important to note, though, that some fixed indexed annuities may have more than one limiting factor. So, if an annuity you own is subject to both a cap and a participation rate, all of these criteria will be taken into consideration.

Is a Fixed Indexed Annuity Right for You?

Even with limited growth, a fixed indexed annuity could still make sense for your portfolio – especially given its guaranteed income feature, as well as the principal protection and tax-deferred growth.

Before you do anything, though, it is important that you first discuss your short and long-term objectives with a financial professional who is well-versed in annuities. At Annuity Gator, it is our mission to educate as many consumers and financial professionals as possible on the ins and outs of these flexible financial vehicles.

If you still have any questions about how annuities work, and whether or not an annuity would be right for you, please feel free to contact us at (888) 440-2468 or send us an email to our secure online contact form. We look forward to assisting you.

Understanding caps, spreads, and participation rates on fixed indexed annuities

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