According to the Financial Industry Regulatory Authority, indexed annuities have seen a major rise in popularity. Unlike some other types of financial products, insurance companies take on the market risk with indexed annuities. Like fixed annuities, indexed products offer premium protection for the annuity owner by guaranteeing a minimum interest rate, i.e., floor, of at least 0.00 percent.
Indexed annuities are tied to the performance of a specific stock market index, such as the Dow Jones industrial average (commonly referred to as the Dow), the S&P 500, or the Nasdaq composite. Interest is credited to indexed annuities based on the change in the index over time. There are several interest crediting methods and additional pricing levers that determine how much interest the annuity will earn.
How Does an Interest Rate Spread Work on an Annuity?
The insurance company sets a percentage for the spread on an indexed annuity each year. This percentage is subtracted from the index change before the interest is credited to the annuity.
The higher the spread, the lower the return. For example, an indexed annuity that uses an annual point-to-point crediting method and has a spread of 2 percent will take the index change from the contract purchase date to the anniversary date one year later and subtract the spread to arrive at the percentage of interest to be credited.
If the index has gained 10 percent on the anniversary date of the contract, the interest credited will be 8 percent — the 10 percent index gain minus the 2 percent spread.
Why Spreads Exist for Fixed Indexed Annuities
Unlike a fixed annuity, for which growth is strictly limited and the insurance company assumes all risk, and variable annuities, for which growth potential is limitless and the annuity owner assumes all risk, indexed annuities offer more growth potential and the insurance company accepts the market risk.
Because the insurance company is contractually bound to credit a minimum rate of interest to the client regardless of how its own portfolio performs, it must restrict the growth of these products if it wants to sustain the product offerings.
If spreads, caps and participation rates were not included in these contracts, carriers would not be able to offer fixed indexed annuities.
In a 2008 letter to the U.S. Securities and Exchange Commission, President & CEO of Wink Intel Sheryl J. Moore argued against subjecting indexed annuities to securities regulation. The rule sought to define the terms “annuity contract” and “optional annuity contract” under the Securities Act of 1933. Moore’s position was that the products are a “safe money place” with a tradeoff of limited upside potential to offset the cost of the guarantees.
In other words, interest rate spreads, caps and participation rates exist so that indexed annuities can exist.
As Moore stated in her letter, “the typical indexed annuity client is an individual who is not willing to risk the principal protection on their annuity for the reward of unlimited interest crediting potential. However, they desire to earn more than what is available via traditional fixed annuity rates, by 1 percent or more.”
The proposal was withdrawn in 2009.
Interested in Buying an Annuity?
Do Rate Spreads Make Indexed Annuities a Poor Investment Choice?
Only the person buying the annuity can decide whether it’s a good financial option. The first thing you’ll want to consider is your objective.
If you fall into the group Moore referenced in her letter — that is, your objective for this particular component of your financial plan is to maximize your money’s growth potential without exposing yourself to the risk inherent in mutual funds or variable annuities — indexed annuities are a viable retirement savings option.
Just remember, indexed and fixed annuities are insurance products, and thus, they are not appropriate for investors seeking capital appreciation. Most of the negative perceptions of all types of annuities, not just indexed annuities, stem from uninformed consumers and misleading sales practices.
That’s why it’s important to find a financial advisor who has experience with annuities and can help you understand how they work and if they fit into your overall wealth management plan, perhaps as a diversification or tax strategy.