Fixed Index Annuities Provide An Interest Rate – How Is That Calculated?
Many wonder do annuities earn interest? The answer is yes, but it can be complicated. We will explain. Fixed index annuities (FIAs) provide an interest rate to their annuitants. Similarly, fixed annuities pay interest as well. The interest in this case is a set rate for the term of the contract. However, the FIA calculation is much more complicated. Instead of using a fixed interest rate, FIA’s use a formula to determine what rate you get.
Mainly, two things impact how the calculation of an FIA interest rate. First, there is the indexing method. The second is the participation rate. Let’s take a deeper dive into what each of these terms means.
Indexing Method Explained
Now that we answered the question “Do annuities earn interest?” Let’s explain further: when fixed index annuities provide an interest rate, their issuer uses an indexing method to calculate it. This index may mimic the market, but FIAs are not dependent on the market. Part of the benefit of this type of annuity? Your principal is protected, no matter what the market does. In summary, your initial money isn’t at risk when in an FIA.
There are three types of indexing methods used for FIA calculations.
(1) Point To Point – First, insurance companies define a certain time period for the “point to point” guideline. For example, once every 30 days, or, once a year at a specified date. Next, we look at the starting value of your index. Finally, the difference between starting value and the “point to point” value is noted. If the change has gone up past a certain percentage, your interest rate for that period may increase. If it went down, you’d still maintain your principal balance. You may also receive a minimum interest rate, depending upon the terms of your annuity.
(2) High-Water Mark – In this method, the fixed index annuities provide a rate looking across a period of time as well. However, it doesn’t measure each change. Instead, the high-water mark method finds the highest point of the index within a set timeframe. Next, it calculates the difference between this and the annuity’s index at the start of the same timeframe. The interest provided is based on this difference.
(3) Annual Reset – As the name suggests, this method is simple. You take the index value at the end of the contract year and compare it to the index value at the beginning of the contract year.
Participation Rate – What Is It?
Indexing methods determine which data points of the index to use for annuity interest rates. But participation rates tell you how much influence that index will have on the interest. The insurance company sets your participation rate once you find your annuity. Usually, for a period of time, this rate cannot change. In addition, the details of your participation rate are specified in your annuity contract. For example, the participation rate may change after a certain period of time. Or, the rate may be set to never go below a certain percentage.
Here is an example of participation rate in action. A participation rate is set to 75% of the S&P 500. Again, this does not mean that your principal annuity value is at risk. It simply means that the index for your annuity in this case is the S&P 500. If the S&P 500 goes up 10%, your annuity would participate in 75% of this increase. Therefore, for that term, you would earn 7.5% interest.
Other Factors To Consider With FIAs and Whether Annuities Earn Interest
In addition to the indexing method and participation rate, there are other important annuity terms to learn. These include:
Floor / Minimum Interest Rate – This defines the lowest interest rate you will ever receive for the term within the annuity contract.
Averaging – Instead of exact point-to-point index values, averaging looks at the average values of that index over a certain period of time.
Ceiling / Cap Rate – Some fixed index annuities, but not all, have a cap rate. This is the maximum interest an annuity can receive.
Margin / Spread / Administrative Fee – This is a predetermined percentage of growth that is set aside before calculating the annuity’s interest rate.