Participation rates are set by indexed annuity carriers to offset the market risk the carrier assumes with the products.
Like fixed annuities, indexed annuities offer the contract holder premium protection, which means that the initial investment cannot be lost regardless of the performance of the insurance company’s portfolio. This perk is what makes indexed annuities insurance products rather than securities, which offer no such protection.
It may help to think of an indexed annuity as a fixed annuity that has a unique method for crediting interest.
The minimum guaranteed interest rate, or floor, on fixed indexed annuities is lower than those of fixed annuities, but the potential gains are higher.
Read More: What Is a Fixed Annuity?
Understanding Participation Rates
Many people find the crediting methods for indexed annuities overwhelming, but talking to a trusted financial advisor can ease some of the anxiety that discourages them from considering these viable retirement savings vehicles.
Participation rates are actually quite simple. The insurance carrier sets the participation rate for an indexed annuity product based on a formula that maximizes its return. Bear in mind that the insurer must earn enough on its investments to credit interest to the annuity, pay its administrative costs and make a profit. If the company can’t make a profit, it won’t sell the product.
Along with caps and spreads, participation rates allow the insurer to limit the upside potential on indexed annuities.
The participation rate is a percentage by which the insurer multiplies the index gains to arrive at the amount of interest they will credit to the annuity contract. For example, according to a 2022 article from FINRA, an indexed annuity with a 75% participation rate would earn 75% of the index gain. If the index was up 13% at the end of the contract term, the insurer would credit 9.75% interest to the client.
Read More: What Is a Fixed Index Annuity?
Indexed Annuities that Use Participation Rates & Spreads
Some FIAs with participation rates are also subject to caps or spreads. This could limit interest earnings further. For example, in the scenario above, if the contract also stated a cap of 8% cap, the annuity would be credited only 8%, as opposed to the 9.75% that would have been credited by the participation rate calculation.
Alternatively, if the contract has a participation rate of 75% and a spread of 3%, the 13% index gain would be multiplied by the participation rate (75% x 13%) and the 3% spread would be subtracted from 9.75%. The interest credited to the annuity would be 6.75%.
How Do Participation Rates Affect Returns on Fixed Indexed Annuities (FIAs)?
As our example illustrated, participation rates limit the amount of interest that can be credited to a fixed indexed annuity. This doesn’t mean that participation rates — or caps or spreads — equate to an inferior financial instrument. It is simply a pricing lever that facilitates the sale of this particular type of annuity.
What it does mean is that indexed annuities are safe products that offer modest returns. These annuities fall between fixed and variable annuities on the risk spectrum, and the typical indexed annuity client is looking for a savings vehicle that can offer a higher return than a savings account or certificate of deposit (CD).
When you buy an indexed annuity that is subject to a participation rate, you’re agreeing to accept a lower return in exchange for the premium protection the insurance company provides by assuming the market risk. If your goal is to earn higher returns, you should consider a variable annuity or an equity investment.