What Is a Cap Rate and How Does It Work in an Annuity?


An annuity cap rate is the uppermost limit on how much a fixed index annuity can grow in value for a certain timespan. The fixed index annuity earns interest based on a benchmark index. When the benchmark index goes up in value, the annuity is credited interest based on a portion of that growth. When the benchmark index falls in value, the annuity is simply credited nothing for that period, and the principal and previous interest earnings stay intact.

The interest credited to an annuity can’t go any higher than the cap rate. Among fixed-type annuities, a fixed index annuity is generally the only kind of annuity that has cap rates. A cap rate is also known as a ‘cap’ in financial circles.

Many retirement savers like fixed index annuities for their growth potential while having principal protection for their money. But in exchange for that protection, that growth potential can be limited by other ways than just caps: participation rates and spreads.

In this article, we will cover annuity cap rates in more detail – and briefly touch on spreads and participation rates, since they also serve as growth limitations for annuities.

Annuity Basics

Annuities are unique financial instruments in many ways. At a basic level, an annuity is a contract between someone and a life insurance company. In exchange for premium money, . They are the only type of retirement vehicle that can provide guaranteed streams of income for someone regardless of how long they live. They are also among the few vehicles that grow tax-deferred without having to be placed inside an IRA or employer-sponsored retirement plan like a 401(k) plan.

There are five main types of annuities: fixed, multi-year guaranteed, fixed indexed, immediate, and variable annuities. Here is a quick sum-up of how each annuity type works:

Fixed Annuities

This is the simplest type of annuity. It simply pays a fixed rate of interest for a set period of time and then resets. It’s not unusual for fixed annuities to be offered as alternatives to bank CDs, bonds, or Treasury securities.

The contract owner’s principal and interest are both guaranteed by the issuing insurance company, so these are generally considered to be pretty low-risk options.

Multi-Year Guarantee Annuities

Although these are also essentially fixed annuities, multi-year guaranteed annuities usually pay a guaranteed rate of interest for longer periods of time than traditional fixed annuities.

Fixed Index Annuities

Fixed indexed annuities guarantee the principal in the contract, but their interest earnings can vary. Again, their growth potential is based on the movements of the underlying benchmark index to which the annuity is linked.

If the index rises in value during a certain period, then the annuity will be credited with interest that is based on a portion of that growth. If the index goes down in value, then no interest will be paid, but no loss will be incurred due to the index decline.

Immediate Annuities

These are the only annuities that don’t offer a period of deferred growth before paying out a stream of income, hence their name. They are also known as “single-premium immediate annuities,” or SPIAs.

SPIAs often start paying out income within a month of the purchase date. SPIAs always pay guaranteed income that can’t be outlived (just as all other annuities can do).

Variable Annuities

This is the only type of annuity where it’s possible to lose money due to market downturns. The money placed into a variable annuity is put into mutual fund subaccounts, which invest directly in financial markets.

Variable annuities are the only annuity type of these five kinds with these direct market investments. They have the greatest potential for growth but also the potential for loss.

What Types of Annuities Have Cap Rates?

Fixed indexed annuities are the only fixed-type annuity that can have a cap rate. Cap rates are one of the three types of growth limits on annuities.

A Quick Word on Annuity Participation Rates and Spreads

Participation rates dictate what percentage of the benchmark index’s gains you will get. For example, a fixed index annuity with a participation rate of 40% means that 40% of the gain in the benchmark index would be credited as interest. Say that the benchmark index went up 10% — with a 40% participation rate, the annuity would earn 4% for that period.

Charging a spread allows the insurance company to claim the first one or two percent of the index growth and then pay you the remaining growth. If the benchmark index went up by 9% and the spread was 2%, then the annuity would be credited for 7% for that period.

How Do Caps Work?

Now, let’s get back to cap rates. Caps are another way that insurance companies can limit your growth. With a cap, there is an absolute limit to the amount of interest that can be credited to your fixed indexed annuity contract.

The spread may dictate that any growth in excess of 10% during a given crediting period is “cut off.” For instance, say that you put $100,000 into a fixed index annuity that is linked to the S&P 500 price index.

If the index grows by 12% during the crediting period, then you would get the ‘first’ ten percent. And you will get the full amount of growth within the cap rate in most cases, with no spread or participation rate to diminish it.

However, some insurers use more than one strategy to limit the amount of growth that you can receive. An insurance company might offer a fixed index annuity with a 12% cap and an 80% participation rate as well.

Insurance companies can raise and lower the caps that they place on their fixed index annuity products. When interest rates are high, insurers can make more money on their reserve monies, which enables them to offer higher growth potential to their annuity owners by raising cap rates. When rates decline, most insurers will follow suit and lower their caps accordingly.

How Do Surrender Charges Affect Your Annuity?

Surrender charges are back-end sales charges by insurance companies to maintain their obligations and discourage policyholder “runs” on their premium money. If an analogy would help here, you can think of the “bank runs” during the Great Depression.

Surrender charges can last for anywhere from 5 to 15 years. Most surrender charge schedules are for 10 years or less. The majority of life insurance companies offer annuities with “free withdrawals,” or provisions that let you withdraw a certain amount of money each year without penalty, such as 10% of your contract value.

This provision effectively leaves you with a measure of liquidity in case of an emergency. The key to understanding annuities lies in the fact that they aren’t designed to be liquid instruments.

If you want to put your money away for three years and then draw it all back out again, then an annuity with a surrender period longer than three years isn’t right for you. You would most likely have to deal with a surrender charge if you needed all of your funds before the end of a longer surrender period.

Talk to your financial professional about your options – and perhaps other options besides annuities – if liquidity is a chief concern of yours.

Understanding Annuities, Cap Rates, and Alternatives

There are many different types of annuities. For much of the 20th century, only fixed and variable annuities were available to the public. Fixed indexed annuities first appeared in the 1990s, and they have evolved since then.

More people are tapping fixed index annuity products because of their moderate to competitive growth potential and also their protection benefit. For those who want more growth potential for their money, looking for fixed index annuity options with strong participation rates or caps might be a good idea. Fixed index annuity products with spreads could potentially lead to situations in down-index years, when the annuity earns zero percent and the spread offsets nothing being credited.  

Fixed indexed annuities offer two very powerful features. The first feature is the growth that you get when your benchmark index rises, because once it has been credited to your contract, it’s locked in for good. You can’t lose that credited interest regardless of what the benchmark index does in the next crediting period.

The second feature that indexed annuities offer is the reset feature. For example, say you started a $100,000 fixed indexed annuity on January 1st and place your money into a given financial benchmark index. The index rises during the first year, so you get credited with a proportionate amount of interest.

The following year, the index drops sharply, far below where it was when you first started. You won’t earn any interest for this year. However, when the next year arrives, your annuity will reset to the new, lower level of the index and start crediting interest from there.

You don’t have to wait for the index to regain its former level before you can earn interest, like you do with mutual funds or stocks.

Is An Annuity with a Cap Rate Right for Me?

If you are looking for growth potential and principal protection from your annuity, then the answer may be yes. Keep in mind that caps are just one part of a crediting strategy with a fixed index annuity. Any fixed index annuities that you are looking at will likely have participation rates, and even spreads, as other options to grow your money.

An experienced financial professional can help you determine whether a fixed index annuity will align with your financial goals and timeline. Don’t be afraid to ask questions and clarify anything until you are comfortable with understanding your options and ready to make well-informed choices.

If you are looking for a financial professional to assist you, or you would like a second opinion of your current retirement plan, then we might be able to help you.

Check out our “Find a Financial Professional” section for independent financial professionals in your area, where you can connect with someone directly for a complimentary appointment. Feel free to discuss your needs, goals, and financial situation. Should you need a personal referral, please call us at 877.476.9723.

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