Comparing Different Types of Indexed Annuities

An indexed annuity, commonly referred to as a ratchet annuity, is a financial contract issued by an insurance company to an individual looking to save for retirement.

In exchange for an upfront payment, the insurer provides the individual, or annuitant, the opportunity to grow his money based on the performance of a stated index, such as the Russell 3000. The insurer also provides downside protection, guaranteeing a minimum rate of return, which will never be less than zero.

Beyond the basic design outlined above, indexed annuities can be structured with a variety of features. We explore the most common parts below.

Minimum Rate

A minimum rate is the guaranteed rate you’ll earn when the index performs poorly. For example, with a minimum annual rate of 1 percent, you can count on this return, whether the index stays flat or decreases significantly in a given year.

Cap Rate

A cap rate is the maximum rate of interest the annuity can earn during a measurement period. For example, an annual cap rate of 6 percent limits upside performance to 6 percent per year. If the index increases by 8 percent, you will only get a 6 percent credit.

Participation Rate

A participation rate spells out the percentage of the index increase you can earn. For example, given a participation rate of 75 percent and a 6 percent increase in the index, your gain will be limited to 4 percent (75% × 6% = 4%).

Spread Rate

A spread rate is a fixed percentage that is deducted from any increase in the index. For example, a spread rate of 3 percent will reduce your gain on a 6 percent increase in the index to 3 percent (6% – 3% = 3%). If the index increases by 3 percent or less, your gain will be the greater of the minimum guaranteed rate or zero.

Crediting Method

The crediting method defines how interest is calculated for a measurement period. Oftentimes, you have the ability to select a preferred crediting method.

Now that we have a basic understanding of indexed annuities and their features, let’s take a closer look at how they’re structured and how they work. The possibilities are endless, but most contracts include some combination of cap, participation and spread features, along with a range of crediting options.

Illustrations of three possible structures and their performances for 2018, 2019 and 2020 are below. For each annuity:

• The starting value is $100,000 as of January 1, 2018.
• Performance is tied to the Russell 3000; interest is credited once per year on January 1.
• The minimum annual rate is 1 percent.

The Russell 3000 monthly performance data is below.

Annual Point-to-point Crediting with 75% Participation Rate

Monthly Sum Crediting with 100% Participation Rate and 3% Spread Rate

Monthly High Water Mark (Annual Lookback Period) with 100% Participation and 15% Cap Rate