Key Takeaways
- Interest rate caps set a ceiling on rates for indexed annuities.
- Rate caps allow insurers to cover operational costs, satisfy interest crediting needs and retain an adequate margin for investors.
- Like interest rate spreads and participation rates, interest rate caps restrict the growth potential of indexed annuities.
- Interest rate caps can change at the beginning of each contract year. The lower the cap, the lower the return.
How Do Interest Rate Caps Work?
An interest rate cap is a limiting feature of an indexed annuity, also known as a fixed index annuity, contract. It enables an annuity provider to put a ceiling on an annuitant’s crediting rate, and most contracts allow the annuity issuer to revise the cap at the beginning of each new annual term.
For illustrative sake, consider the following example:
You own a fixed index annuity with an interest rate cap of 12%. Its crediting rate is tied to the S&P 500, and during your first contract term, the S&P 500 increases by 17%. However, your annual interest credit is limited to 12%, given the ceiling created by the cap.
Read More: Current Annuity Rates
You can think of rate caps as a type of fee or cost (though they’re not technically a fee). If you want to transfer the downside risk to the annuity company, there is a cost associated. In the case of indexed annuities and RILAs, the cost is the cap on interest rates.
Chip StapletonFINRA Series 7 and Series 66 License HolderChip Stapleton is a financial advisor who has spent the past several years of his career working primarily in financial planning and wealth management. He is a FINRA Series 7 and Series 66 license holder and passed the CFA Level II exam in 2022.
Why Do Rate Caps Exist for Indexed Annuities?
An insurer that sells indexed annuities must run a profitable operation to maintain and grow its book. Doing so means investing in a manner that enables the insurer to satisfy its interest crediting obligations, cover its administrative costs and retain an adequate margin for investors.
Operating profitably is tough for any business. For indexed annuity issuers who guarantee their customers no risk of loss, the challenge is significantly elevated.
This is where interest rate caps come into play. These pricing levers enable insurers to mitigate their economic risk by limiting annuitants’ upside potential and establishing a more equitable risk-return tradeoff. In down market years, insurers will suffer financial losses, but they can make up for them in up market years.
Interest rate caps, interest rate spreads and participation rates exist so that indexed annuities can exist. Without them, investors would not have the ability to passively participate in positive markets with no downside risk.
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Do Rate Caps Make Indexed Annuities a Poor Investment Choice?
As outlined above, interest rate caps restrict the growth potential of indexed annuities, which enables annuity issuers to provide downside protection. The limiting nature of an interest rate cap (or an interest rate spread or participating rate) does not make indexed annuities inferior to other investments.
Rather, it serves as a pricing lever that enables insurers to sell this type of annuity. When you buy an indexed annuity that is subject to a rate cap, you are agreeing to accept a lower return in exchange for principal protection. You give up some upside potential, but the annuity provider has assumed all the downside market risk.
If forgoing potential returns is undesirable, perhaps you should invest in diversified stock funds, a real estate investment trust (REIT) or a variable annuity. Consult with a fiduciary financial advisor to assess your unique situation and identify the investment vehicles that make the most sense for you.
Other Frequently Asked Questions About Rate Caps
Fixed annuities are typically the safest type of annuity contract you can buy. They provide a fixed rate of return and exhibit zero volatility. Indexed annuities are modestly riskier because their returns can fluctuate. Variable annuities are the riskiest type of annuity contract; they entail investment positions in volatile assets, which expose investors to the possibility of loss of principal.
An interest rate floor is the guaranteed minimum rate of return provided on an annuity. Stated as a percentage, it is the minimum amount of interest you can expect to be credited to your annuity for any given contract year.
Like an interest rate cap, an interest rate spread is a limiting feature of an indexed annuity. Essentially, it is a hurdle that must be cleared before interest is credited to an annuity contract. For example, if an indexed annuity has a rate spread of 4% and the specified index increases by 13% during a measurement period, only 9% will be credited to the annuity’s value (13% index performance less the 4% rate spread).
A participation rate is a type of limiting feature of indexed annuities. Stated as a percentage, it specifies the extent to which an annuitant can participate in the performance of the index specified in the annuity contract. For example, if an indexed annuity has a participation rate of 75% and the specified index increases by 16% during a measurement period, the interest credit will be limited to 12% (75% × 16% = 12%).
Some indexed annuities with rate caps are also subject to participation rates or interest rate spreads, which can further restrict growth potential. For example, if an indexed annuity has a rate cap of 11% and a participation rate of 75% and the specified index increases by 20% during a measurement period, the interest credit will be limited to 11%. The participation rate implies a credit of 15% (75% × 20% = 15%), but the cap limits the credit to 11%.
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