If you are considering a fixed index annuity for your retirement goals, you may have heard of different ‘crediting methods’ tied to an indexed annuity and how your money can grow with them. But what is a fixed index annuity, and how does their growth exactly work?
Fixed indexed annuities are a tool for building up retirement savings on a tax-advantaged basis. They are becoming more popular for many retirement savers, as they let your money grow by earning interest, protect your principal against losses, and offer a guaranteed income stream in retirement.
If you are thinking about this retirement-saving option, one key aspect is understanding fixed index annuity crediting methods. These are the means by which your annuity money can earn interest.
A fixed indexed annuity usually has a fixed option that will pay a guaranteed rate for a certain timespan. However, indexed annuity crediting methods aren’t guaranteed, but they generally offer growth potential above the fixed option. You can also have more growth potential with a fixed index annuity than other types of fixed annuities.
In this article, we will go over the different types of crediting methods, their components, and how these crediting methods work. These annuity crediting methods are linked to underlying index benchmarks. Those benchmarks can be everyday financial indices that you know (the S&P 500 price index) or niche indices that focus on domestic, foreign, or different asset classes.
Indexed Annuity Crediting Method Components
Before diving into the crediting methods, it’s good to know their core parts. Life insurance companies build out their indexed annuity crediting methods on three components:
- Participation rates
Caps are absolute limits imposed on how much your money can grow in a fixed indexed annuity within a given period. For example, say that a fixed index annuity has a cap of 10% and the timespan is for one year.
That means that the most that the annuity can earn in that year is 10%, regardless of how much higher the underlying index goes. This limit can be noticeable in years when the benchmark index has high growth, such as 25%.
Participation rates are another way to limit the growth that someone can reap within a given crediting period. A participation rate of 60% means that you will get 60% of the growth of the underlying benchmark index, regardless of how much it grows.
This crediting method can result in higher overall growth in the contract over time than one with a cap rate. Some fixed index annuities allow you to choose an enhanced participation rate in the form of riders. However, these are also available for a fee or charge.
The third way that insurance carriers can limit the amount of growth in a fixed indexed annuity is with a spread. The spread would apply for a crediting period, such as for a year.
Let’s say that the spread is 2% and the index goes up by 10% for the year. In that case, the insurance company would take 2% off that 10% growth. This can be a nice feature when the benchmark index has a big gain for the year.
For example, if the index rises by 15% during a given crediting period, then the 2% spread would be minimal compared to that increase. This doesn’t necessarily happen often but can be a nice option to have when index growth is high.
Why Do Crediting Methods Have Limits on Growth?
Why your growth potential is capped is for a variety of reasons. First, your fixed indexed annuity provides principal protection, meaning that your principal and prior interest earnings are protected from losses. The limited growth potential is a trade-off benefit for that.
It also helps the life insurance company offer reasonable growth for your money, remain in business, and keep its promises to you and many other contract holders. Finally, the growth potential is strongly tied to the options budget that the insurance company has for its fixed index annuity contracts.
Ninety to ninety-five cents of every dollar of indexed annuity premium are put into conservative, low-risk investments like bonds. On the other hand, three to five cents of every dollar go toward call options on the indices that you choose (which you can choose in different crediting methods, more on that later).
More on Crediting Methods in Up and Down Periods
Each crediting method is tied to an underlying benchmark index. However, no crediting method is ever a direct investment in investment markets. A crediting method is simply a way for your annuity money to earn interest.
In years of positive index returns, your money may earn interest depending on the amount of growth and the crediting method chosen. The growth potential for your money is generally above that of a fixed annuity or other fixed-interest investments, such as bonds, CDs, Treasury securities, and so on.
In those years when the index goes down or stays flat, your money is protected. Your contract is simply credited zero percent, so your money won’t go down due to negative index returns (unless you opt for a rider in the contract that can do things like pay guaranteed income for life).
Common Examples of Different Crediting Methods
– Annual point-to-point
This crediting method is fairly straightforward. It simply compares the difference between where the underlying benchmark index is at the beginning of the contract year and where it lands at year end.
For example, say that you buy an indexed annuity and choose one benchmark index, such as the S&P 500 price index. The insurance company will look at the value of this index on the date that you started your annuity and then compare it to where the index is exactly one year later.
So, if your annuity contract started on September 1, 2021, then the carrier will look at the index value on September 1st of 2022. If the index is higher by that time than it was the year before, then the insurance company will credit your contract with a proportionate amount of interest.
However, if the index fell in value over the year, no interest would be credited. But the value of your annuity wouldn’t decline because your principal is protected.
Let’s say hypothetically that an index did rise in value over the past year. The index was hypothetically at 280 on September 1, 2021. Assume for the purpose of this example that the index closed at 294 on September 1, 2022. Your interest would be calculated as follows:
294/280 -1 = 0.05
Cap rate = 6%
Amount of growth credited to your annuity = 5%
– Biannual point-to-point
This is the same as the previous example, except that a two-year period is used. Biannual point-to-point strategies have often slightly outperformed annual strategies over time. This is because the insurance company can invest your money in underlying investments with a longer maturity and thus earn a higher yield.
– Triannual point-to-point
Again, this is the same concept as the annual strategy, except that a three-year period is used. As with the biannual strategy, you will most likely get a higher rate of return with this strategy because the insurance company can invest in instruments with longer maturities.
– Participation rate
This form of crediting uses a percentage of the index’s growth for its crediting formula. Let’s assume again that your contract start date was September 1, 2021 and the index was at 280. On September 1, 2022, the index closed at 294. Let’s also say that the participation rate is set at 65% of the index growth.
If you chose the participation rate, your interest earnings would be based on 65% of the index gain. So, your interest would be calculated as follows:
Index growth = 5% (0.05)
Participation rate = 65% (0.65)
0.05 X 0.65 = 3.25% interest credited to your annuity balance
– Monthly sum
This crediting method is a bit more complicated than the previous methods. The monthly sum method accounts for all the capped cumulative monthly changes in the index during the preceding year.
When the index rises in value in a given month, the amount of growth that is plugged into the crediting formula is capped at a certain amount. The “floor” or principal guarantee doesn’t apply when the index drops in value in a given month.
Following is an example of how your interest would be calculated based on the previous examples. Assume that the monthly cap rate is 1.5%.
% Index Change
3.5% (capped at 1.5%)
2.5% (capped at 1.5%
5.0% (capped at 1.5%)
Now, we total all those percentages to determine the amount of interest that you will earn for the year. The total comes out to -1% in this case, which means that you won’t earn any interest for this year.
In this case, you can see where one of the other crediting methods listed would have been more profitable for you than this one.
Which Indexed Annuity Crediting Method Is Best?
Over the long term, no crediting method is typically the “best” or works better than its counterparts. In the short term, some crediting method options may do better.
Instead, you may want to look for fixed indexed annuity contracts that have straightforward crediting methods and index options. That can make it easier to keep comparing different annuities.
Even so, some companies that offer “simple” crediting methods generally use a somewhat complex formula to calculate the exact amount of interest that they owe you. The examples above have been simplified to show you the basic concepts.
You can also ask your financial professional about a specific insurance company’s history with ‘renewal rates,’ or the rates for growth potential that the insurer offers after a contract year has passed. Not all life insurance companies are generous in this area. Some also publish their renewal histories publicly.
All insurance companies also have minimum rates for participation rates, caps, and spreads. Their histories of what those are set at can be a clue-in of how an insurance company might be for future growth potential for your money.
Don’t Buy for Annuity Crediting Methods Alone
It’s good to keep this in mind: annuities don’t offer the strongest benefit for their growth potential.
Their biggest advantage is the contractual guarantees which they offer you in retirement. Guaranteed income for life, guaranteed protection against index losses. For fixed-type annuities and the fixed option on indexed annuities, guaranteed growth. Some fixed indexed annuities also come with death benefit guarantees.
If you are looking for guaranteed benefits in retirement, these are perhaps the biggest areas to focus on. It’s good to buy an annuity for what it will do for you, not only what it might. Ask your financial professional about what sort of contractual guarantees may be available on the fixed indexed annuity products which you might be exploring.
Other questions that you can ask your financial professional include the level of diversification that you get from a given index. If you choose to use the S&P 500 Index, then you have wide diversification.
Other common indexes that are used are tech stock indexes and Nasdaq indexes. Some benchmark indices track separate asset classes, such as stocks, commodities, and bonds.
Remember, you can usually divide your money between several indices if you like; you generally don’t have to put all your money into just one index. You can also have more than one crediting period, such as half in an annual point-to-point and half in a two or three-year point-to-point.
It is also good to find out how long a given financial index that your advisor recommends has been around. With the explosion of new fixed index annuity products that have flooded the marketplace, many new indices have been created based on consumer demand. But these new indices have no historical track record except from backdated historical data-which is not always a clear indicator of future performance.
Are you looking for a financial professional to help you with understanding your options here? Perhaps you have a broader need, such as wanting someone to look at your existing retirement strategy or come up with a plan for your financial future.
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