Retirement Planning: Protect & Grow Your Assets

An annuity is a contract between you and an insurance company, where you exchange a payment (or series of payments) for a guaranteed income stream or accumulation. Indexed annuities are a popular type of annuity where the interest credited to the contract is not declared in advance by the insurer; instead, it is based on the performance of an independent market index, such as the S&P 500.

For example, if the index to which Index Annuity ABC is tied was at $1,000 when the contract’s interest crediting period began and reached $1,100 when the crediting period ended, the index increased by 10% [($1,100 - $1,000 = $100) ÷ $1,000]. Consequently, the basis for the interest that will be credited to Index Annuity ABC for that period is 10% subject to participation rates and/or caps. In this way, indexed annuities allow some measure of participation in market-based returns: the increase in the index to which the product is tied is the basis for the amount of interest that will be credited. This crediting is most commonly done on an annual basis with a reset for the next 12 months.  Finally, an indexed annuity typically has a floor of zero, thereby protecting the original principal regardless of the index's performance.

Indexed annuities also provide for a minimum guaranteed interest rate, which protects the values in the contract against market downturns. At the end of each interest crediting term, the indexed interest or the minimum guaranteed rate, whichever is greater, will be credited to the contract. In this way, an indexed annuity buyer’s principal is protected from loss so long as withdrawals are not made during the contract's surrender period. It is common for indexed annuity insurers to apply the guaranteed minimum rate to only a portion of invested premiums, such as 87.5 or 90%.

The participation rate is the percentage of the index increase that will be credited to the contract. For example, if the participation rate is 80% and the index to which the contract is tied increased by 11% over the crediting period, then the contract will be credited with 8.8% interest (.80 × .11 = .088).

Indexed annuity participation rates vary widely from insurer to insurer and from product to product. Some may be as low as 50%; others may be as high as 100%+. Products with lower participation rates may feature additional benefits that are not included on products that apply higher participation rates. Conversely, products that have longer terms may carry higher participation rates than those with shorter terms. Participation rates are commonly subject to change with each crediting period reset.

In addition to a participation rate, indexed annuities usually impose a cap, which is the maximum amount of interest that will be credited during any one interest crediting period. An 8% cap, for instance, limits the amount of interest credited to the contract in any interest crediting period to 8% regardless of the performance of the underlying index and regardless of the participation rate. Caps are commonly subject to change with each crediting period reset.

As with traditional fixed annuity contracts, insurers provide for guarantees on their indexed products. For example, the insurer guarantees that:

· No less than the contract’s guaranteed minimum rate will be credited to the contract.

· A specified percentage of gain in the associated index will be credited if that amount is greater than the guaranteed minimum rate.

Therefore, insurers must invest carefully to ensure that they can meet their contract guarantees. The premiums that an insurer receives for its indexed annuities are applied to cover four things:

· the contract’s underlying guaranteed minimum rate of return, which is typically covered by the purchase of bonds and bond-like instruments

· contract expenses (including administrative and sales expenses)

· the insurer’s profit

· the interest crediting that is associated with the indexed strategy. 

This is usually covered by the purchase of index call options. By purchasing call options, the insurer is guaranteed that it will have the necessary funds to credit indexed interest greater than the minimum rate guaranteed in the contract. Purchasing an index call option gives the insurer the right to demand and receive a specified amount of cash from the index writer.

When premiums are allocated to an indexed strategy, the insurer must determine how much of that premium is available to purchase index call options—in short, the insurer must figure an index call option “budget.” To determine this budget, the insurer deducts from those aggregate premiums the costs associated with the other aspects of the contract, namely the cost of the required bonds, the expenses for administration and sales, and profits. The balance of premiums remaining is the index call option budget. If the insurer is able to effectively manage the other costs and aspects of the contract, it will have a larger amount with which to purchase index call options.