A Growth Focused Index Annuity

The Truth About Hybrid Index Annuities

hybrid index annuities

Many investors are introduced to index annuities with income riders at dinner seminars and through TV and Internet advertising.  Often cloaked in marketing terms like ‘hybrid index annuities’ or ‘Next Gen Annuities’, these are typically index annuity contracts bundled with income riders and other add on benefits.

Indeed, many people coming to us at DCF Annuities think that monthly income with long term care benefits are the ONLY thing index annuities do.

In reality, index annuities first and foremost should be considered a safe money allocation, a place where your capital is protected from loss.  They are safe, and in their purest form, they are simple and efficient.

But insurance companies are in an arms race to add riders, options, and benefits to these basic contracts.  People like a silver bullet, one-stop shopping solution, and these hybrid annuities are to retirement planning what WalMart is to retail.

There is nothing inherently wrong with index annuity contracts that are bundled with income, long-term care, and death benefit riders.  They do the job they are intended to do.

But the question is, is it a job you need done????

Index Annuities With Income Riders Are The Jack of All Trades Annuity

But, as everyone knows, the jack of all trades is the master of none.  When an annuity has every feature and benefit available, the sum of those parts drags down performance of the whole thing.

In short, an annuity that tries to do everything will do no one thing very well.

With every benefit, feature, or rider, there are costs to the insurance company.  The more benefits, the more expensive it is to offer the contract.

It’s only natural then that benefits get toned down to manageable levels for the carrier.  It’s not wrong, it’s just business- there is no such thing as a free lunch.

In the end, many of the components of a ‘hybrid annuity’ ultimately do not offer as competitive a benefit as you can find through ‘pure play’ offerings.

Understand the Features, Benefits, AND the Costs

Let’s look through each of the bundled benefits typically seen in a hybrid annuity contract, and outline the ‘pure play’ alternative options.

Need long term care? Buy long term care insurance, instead of relying on a watered down rider in the annuity.

Need lifetime monthly income? A pure income contract, when purchased at an optimal time, will outperform nearly all other options.

Need to leave an inheritance? Life insurance has been used for centuries for exactly this need, and it’s tax-free to the heirs. Also, a longterm lump sum or fixed annuity contract placed today guarantees the future outcome you desire.

Need income for a few years?  Period certain Secondary Market Annuities are more efficient and higher yield.

Need safety of principal? Growth-oriented index annuities protect principal with market-linked growth potential.  More efficient, no fees

Need options? In many situations, using the free withdrawal provision of a growth-oriented index annuity for income needs is more efficient than any income rider.

What Benefits Do You Need?

If you are like most of our clients, chances are good that you already have some guaranteed income and have protected some of your assets.

You may have guaranteed income from another annuity, a pension, real estate, or some other source. You may only need to make a few enhancements to your plans and investments.

But most likely, there is something about an annuity that appeals to you, which is why you’re reading this page.

The first step is to identify the benefits that appeal the most and that you need the most.   Then it’s a much easier matter to pick right annuity for you in retirement.

These are the primary components that can be isolated- there are contracts that maximize one, or sometimes two of these components.  Put all three into one contract, however, and all will suffer.

  • Safety: Annuities are safe money allocations that in most situations offer superior qualities to most other ‘safe money’ asset classes like bonds. See ‘Annuities are Enhanced Bonds
  • Growth: Index annuities were made to capture a reasonable amount of growth in good times and lock in that principal and prior earnings down times. See ‘Growth Oriented Index Annuities’
  • Income: If you want maximum income then focus on a contract that is specifically designed for income alone. See ‘Index Annuities For Income

Pros and Cons of Index Annuities

pros and cons of index annuities

Retirees and conservative investors seeking a clear analysis of the pros and cons of index annuities are in the right place.

Index Annuities have gained in popularity, market share, and strength in the years since they were unveiled to the market. Sales of fixed indexed annuities hit a record $17.6 billion in the second quarter of 2018, 21% higher than first quarter sales results, according to LIMRA Secure Retirement Institute, an industry group

Index annuities offer a series of advantages over traditional annuities that savers and investors for retirement simply can not ignore. These include:

  1. Tax-deferred growth
  2. No loss of principal regardless of market conditions and performance
  3. Lock in and guarantee credited earnings 
  4. Access to funds through partial withdrawals
  5. Risk-free market participation without downside exposure
  6. Multiple index crediting methods and strategies
  7. Carrier guarantees and reserves back and guarantee these annuity accounts

We will look at the pros and cons of index annuities in greater detail on this page.

Pros and Cons of Index Annuities: Pros

Index annuities have gained in popularity for many good reasons. In this section we will consider seven different compelling reasons to seriously consider adding them to your retirement strategy and portfolio.

1) Index Annuities Create Growth that is Tax-Deferred

One of the greatest advantages to Fixed Index Annuities is that they create earnings that grow tax deferred. Income taxes are not due on gains until they are withdrawn from the annuity. Index annuities can be purchased with after-tax investment dollars and shield the growth of assets from taxes.

2) No Loss Of Principal Regardless Of Market Conditions and Performance

The greatest appeal of Index Annuities to most people saving for retirement is that they can not lose money regardless of what happens in the stock markets. The insurance company will invest the premiums from the annuities into a proprietary mix of safe investments.

Next they back this up with their own considerable financial reserves. This gives the invested money great protection and a solid guarantee that individuals planning for retirement need to be able to count on as they approach the years in which they will require payments to be made.

3) Lock In and Guarantee Credited Earnings

It is not just the principal that is guaranteed by the insurance company contract in an annuity. Interest that has been credited to the account also enjoys this loss protection guarantee. Such safeguarded principal and earnings protection is an invaluable advantage to have as market volatility and setbacks arise from time to time.

4) Access to Funds Through Partial Withdrawals

It is important to compare apples to apples with annuities and surrender periods. Other safe money investments like annuities have these surrender periods that tie up the funds for certain preset periods of time. Both government bonds and certificates of deposits include longer-term commitments.

The difference between them and the annuities is that with annuities, it is possible to access some funds while gaining protection from the risk of interest rates that plague bonds much of the time.

5) Risk Free Market Participation Without Downside Exposure

One of the primary advantages of index annuities over variable annuities is that variable annuities do not offer protection from losses.  Variable contracts offer participation in the gains of equities markets, but they also had exposure to market losses.

With Fixed Index Annuities though, investors have participation in selected underlying stock market indices, without downside risk.

The are a host of crediting methods and options in the contract that will determine what percentage of the potential underlying market gains that annuities holders actually receive. It allows for investors in annuities to access significantly higher yields than traditional and rival safe haven assets can deliver.

6) Multiple Index Crediting Methods and Strategies

There are many different Index Annuities today in the market that allow protected growth in a wide range of markets

Like Emerging Markets?  There’s an annuity for that.

How about Gold? Got that covered too

Interested investors have a wide range of underlying index and markets to chose from.  The rates and crediting methods all vary as well but whatever your preference, the annuity market will offer some sort of option that suits your fancy.

7) Carrier Guarantees and Reserves To Back Accounts

Consumers and investors have a long-standing trust in the financial strength of insurance companies in America today. This stems from their often hundreds of years of reliability, financial dependability, and profitability that other industries and firms simply can not match. All principal and earnings of Fixed Index Annuities are guaranteed by a contract provided by the issuing insurance company.

Besides this inherently powerful contractual guarantee, the insurance companies that issue annuities are required by law to set aside substantial reserves. These will cover any possible claims policyholders could bring in an unlikely scenario.

So when an underlying index on a given Fixed Index Annuity declines, even significantly, the principal remains intact and the interest for the year is zero percent. It is never negative or a loss. This explains why there are so many individuals who feel like they need annuities today.

Pros and Cons of Index Annuities: Cons

An honest review of any annuity product will also include a realistic look at the limitation of the instrument. They are not ideal for every investor or retirement planner. The cons of Fixed Index Annuities include:

  1. The safety trade off is limited growth
  2. Initial investment costs are quite high
  3. A few bad days can dramatically impact final returns for the year
  4. Surrender periods are lengthy
  5. Index annuities involve complicated crediting methods
  6. Index annuities mostly include topside cap limitations on market performance
  7. Index annuities are not protected against inflation

1) The Safety Trade Off is Limited Growth

There is a price to pay for the safety that these Fixed Index Annuities provide. A reduced and capped growth is this price that annuity holders must accept. Some investors will feel that this is too high a cost to bear.

2) Initial Investment Costs Are Quite High

This downside is primarily applicable to index annuities with income riders.  In order to secure the monthly income you desire, you may feel that the initial premium is too high.  As we talk about in the Truth  About Hybrid Index Annuities, these income rider products are not always the most efficient way to generate lifetime income.

3) A Few Bad Days Can Dramatically Impact Final Returns for the Year

Because the majority of interest credits only a single time each year, the potential earnings often rely on the final market results from one or several days. If the markets were to sharply decline towards the conclusion of the crediting period, this could eliminate the majority of anticipated gains.

4) Surrender Periods Are Lengthy

Potential investors in these annuities need to be comfortable with the lengthy surrender periods that many of these annuities require. While good growth oriented index annuities have short surrender schedules (3 to 7 years), more complex income rider contracts may have surrender schedules as long as 15 years.

Early withdrawals are allowed, and without penalty, but if you need to surrender, it can be costly.

5) Index Annuities Involve Complicated Crediting Methods

No honest broker or insurance company will try to tell would-be investors that the crediting methods for Index Annuities are simple.  Quite the opposite.  Crediting methods can be shockingly complicated thanks to all of the many strategies and options on offer. This is why it makes real sense to have a  clear idea of what you need, before getting into the details.

7) Index Annuities Will Have Caps And Limitations on Market Performance

The majority of Fixed Index Annuities today come with limiting caps on the performance results for the underlying market index. The annuity holder will receive interest paid on the annuity balance as a result of the market performance, but subject to caps, participation rates, or a spread.  As with anything, there is a price for the safety and other benefits, like downside protection.

8) Index Annuities Are Not Protected Against Inflation

Index Annuities do safeguard against portfolio declines, but they are not foolproof. Inflation is the erosion of purchasing power and if you buy an income rider on a fixed index annuity contract that has a level income benefit, you may find that over time that monthly check buys less and less.

Will he guarantee your money? No Way!

Final Thoughts on The Pros and Cons Of Index Annuities

While it’s important to keep in mind several downsides to Fixed Index Annuities, remember that first and foremost you are buying safety.  What money manager is willing to guarantee that you will never lose money? Not this guy you see all over the web!

Using Index Annuities for Retirement

index annuities for retirement

Retirement in this century is very different than for previous generations, and as such the planning and tools needed for the 21st century have naturally evolved from the basic tools of last the millennium.

A hundred years ago, the prevailing wisdom that is unfortunately still bandied about was “buy stocks when young for growth, and bonds as you age for income.” While the essence of this advice is still sage and relevant, it has improved over the decades into a more efficient approach that manages the various risks much better than the ancient way.

Look at some of the factors that have dramatically altered retirement from your grandparents:

  1. Longevity: life expectancies are 30+ years longer than a century ago.
  2. Decline of the nuclear and localized family: rarely are relatives living in the same house or next door.
  3. Rise of Long-Term Care needs: one half of those 65 years old today will need care.
  4. Decline of pensions: the majority of current retirees have pensions. Most pre-retirees do not.
  5. Social Security has not kept pace with inflation.

The net effect of these forces is that retirement will last longer than ever before, with a much greater share of the burden on the individual. The traditional bond-heavy retirement portfolio completely fails to address this new reality and leaves people highly at risk of running out of money as they age, creating uncertainty and fear that clouds the golden years unless addressed.

Luckily actuarial science and financial innovation have been applied to this dilemma, and there are a variety of solutions to these problems. One of the most flexible is the use of index annuities as a bond substitute in retirement planning to eliminate many of the shortcomings of the traditional bond approach.

Many people shudder when they hear the term “annuity”, based upon decades-old beliefs drawn from outmoded annuities with their lack of customization and locked in limited choices. Thirty years ago this was reality, but financial evolution has led to what we have today with the index annuities and their characteristics of:

  1. Fairly consistent annual growth
  2. Low fees relative to variable products
  3. Potential for inflation protection over time
  4. Lifelong income if desired
  5. No downside in down markets
  6. Ability to access cash without penalty

These characteristics make them a smart option for those investors who are looking for security, safety, flexibility and income in retirement years.

Like any financial product, Index Annuities may be right for some people and wrong for others.  There are definitely situations where they are not the best tool, so to understand if they are right for you, let’s discuss just how they work.

Understand the Difference: Index Annuity or Hybrid Annuity?

Annuity marketers have muddied the waters and Index Annuities been called Hybrid Annuities in the past. The nickname “Hybrid Annuity” is really a marketing phrase applied to those annuity contracts that combined a number of different benefits and advantages into a single contract.  Be sure to read our page on  The Truth About Hybrid Annuities on this site for our take on the products.

In a broad sense, the idea was to take the best features of different types of annuities and assemble something better by putting them all together. Benefits combined into one contract that were previously unavailable had the result of a dramatically increased level of complexity, coupled with customizability of the new generations of annuities.

With Innovation Comes Misconception

For better or worse, hybrid annuity contracts and the associated marketing have fanned widespread misconceptions and counter- marketing attacks.  Most misconceptions stem from legacy beliefs about Variable Annuities.

General financial misunderstanding runs rampant in the public, often fed by talking heads such as Suze Orman and Dave Ramsey in an attempt to sell books/programs (or commercials on their shows).  CNBC and the Wall Street Journal feed the fires by picking out “worst of the worst” to showcase and then painting all annuities with the same brush.  Finally, Ken Fisher’s incessant advertising for his managed money platform adds more noise to the marketplace.

All these individuals and companies are focused on short-term attention to garner eyeballs, and not long-range growth with flexibility tailored to individual needs.  They have focused on ‘annuities’ as a term and as an industry for their attacks, and the industry has failed to defend itself well.

Some of the attacks you may have heard, and a few rebuttals, include:

  1. Inaccessible. Insurance and annuity contracts are a generally illiquid or restricted product.  But current hybrid annuities have a variety of ways to access the cash, so this is highly misleading fear mongering, based on old info, and is simply moot if the purchaser is properly informed.
  2. Illustrated returns. Many marketers advertise a misleading teaser rate, such as “8%*”, with fine print that can leave your head spinning.  In response to this, we educate clients on how returns are really calculated and do not rely upon smoke and mirror numbers, because transparency is the only way to make choices for the future.
  3. Guaranteed returns. Traditional money managers scoff at even the word ‘guarantee’, but usually it’s because they simply can’t compete.  They live in a world of probabilities and risk, and insurance is on another planet, one of risk mitigation. Premium in a hybrid annuity or index annuity does have a guaranteed minimum interest rate per contract, and the asset itself is backed up by the full and faith of multi-billion-dollar companies and backstopped by external guarantee funds. Traditional bonds have far less security in the promises backing them up.
  4. Excessive hidden fees. Whether they are hidden or overt, fees erode real returns.  The talking heads however will typically look no further than the admittedly egregious variable annuity fees, with mutual fund costs, rider fees, and insurance charges that may total 5% or more per year.  I agree completely- these doggy products don’t belong in anyone’s portfolio.  But does that mean all annuities are bad? No way.
  5. Low returns. Comparing the guaranteed base return of an index annuity to the short-term performance of a non-guaranteed bond fund is bad math, as it ignores the guarantee inherent in the annuity, namely, that your principal will never lose value.  It’s even more misleading as the taxation on the bond fund negatively impacts yield, whereas annuities grow tax deferred.  If you were to calculate after-tax returns per unit risk, growth oriented index annuities over and over again trounce whatever hot new fund is trotted out on TV.

To be sure, there are some hybrid annuities that do have poor performance and higher fees.  But quality contracts with quality companies don’t play these games, and if we invest the time upfront to understand how they work and the restrictions that should be planned around, we can make better decisions.

Using Index Annuities for Retirement Income

types of annuities

The classic use of an annuity was to convert a lump sum of money into an income stream for a lifetime, essentially creating something like a private pension plan with a monthly paycheck.

For many people this makes perfect sense, as it removes the longevity risk discussed previously that is a major weakness of the traditional bond portfolio approach. But not every consumer has identical needs or goals, so the flexible nature of hybrid annuities is a major advantage as they can be individually customized based on need.

How Index Annuities Work for Retirement Income

Index Annuities provide the potential to earn greater returns by participating in appreciation of the equities markets while still guaranteeing a minimum annual growth. And when coupled with income riders, so-called ‘Hybrid Annuities’ may  also deliver the following advantages in one neat package:

  • Lifetime income – while avoiding any volatility in markets.
  • Emergency liquidity – in times of need.
  • Home-based health care – accelerated payouts for pressing medical needs that arise.

An interesting case study is the country’s top-selling annuity, the Allianz 222, which has become a widely used product for a reason. Its popularity is due in large part to the massive bonus paid to the buyer that has topped out at 30 percent in some cases. Beyond this, it provides owners with an additional 50 percent of all interest that the insurance company credits each year.

This sounds impressive, but as with anything in life, there is no such thing as a free lunch. Understanding this particular Index Annuity for Retirement Income is easiest by analogy to Social Security or any other long-range asset: the longer a retiree waits to take it, the more they will receive. The old adage “good things come to those who wait” is 100% applicable in this situation. If you hold your Allianz 222 for 10 years there is extra value.

Account Value Versus Protected Income Value

There are two concepts that some annuity buyers sometimes have trouble getting their heads around: Protected Income Value and Account Value.

  1. Protected Income Value – This may also be called the ‘income base’ or other names, depending on the contract.  It is a non dollar account value comprised of the premium an annuity holder invested plus the amount of the premium bonus. This amount is then typically increased, or rolled up annually and may be enhanced by other bonuses. The final total is what the insurance companies use to determine guaranteed lifetime income that the annuity owner will get.
  2. Account Value – this equals the invested premium plus interest credited during the contract term. This is usually lower than the Protected Income Value, and if the client transfers the asset to a different annuity will be the starting amount for this transfer calculation.

Going back to our Allianz 222, the contract language eloquently states:

The premium bonus and interest bonus are credited only to the Protected Income Value. To receive the PIV, including the bonus, the contract must be held for at least 10 contract years, and then lifetime income withdrawals must be taken.

Be sure to read our Income Oriented Index Annuities and our piece on Understanding Index Annuity Rates for more on the various terms related to index annuities.

Final Thoughts on Index Annuities and Retirement Income

So let’s review a few important points from this article:

  1. Retirement is very different now than it was 50 years ago. Flexibility is of paramount importance as people and markets change.
  2. The “buy bonds for safety” of the past has evolved to “buy annuities for safety, flexibility and income” of today.
  3. The generic, one size-fits-all solution has evolved into customized tailoring of products to meet individual needs.
  4. Index Annuities have the flexibility and options to fill many individual needs and are often a good option for long-range planning.

Here at DCF Annuities, we have the expertise to tailor a solution based on your individual annuity needs. If you are like many of our clients, you probably now have additional questions related to your individual circumstances based on reading this article. Our team at DCF Annuities is happy to help with any questions that you may have, please contact us today for more information or to speak with a representative by phone (800) 246-1932.

Understanding Index Annuity Rates & Crediting Methods

index annuity rates

There are a range of rates to consider when researching fixed index annuities, and a host of new terms to understand about interest crediting methods. Indexed annuities are increasingly popular with investors looking for reasonable growth, tax deferral, and guaranteed principal protection, but just because they are popular does not mean they are easy to understand at first glance!

There are several rates and crediting methods that work together to generate the interest income yield for any given contract.  On this page, we will de-mystify the various index annuity rates and crediting methods that you will encounter to help you compare different contracts on an apples-to-apples basis and make informed decisions.

Key Index Annuity Rate Terms:

There are a host of terms that you may encounter in a fixed index annuity contract:

  1. Crediting Rate & Crediting Method
  2. Cap Rate
  3. Participation Rate
  4. Spread, or Margin Rate
  5. Guaranteed Minimum Rate
  6. Rollup Rate
  7. Payout Rate
  8. Bonus Rate

Key Index Crediting Method Terms:

Tightly related to the Crediting Rate is the Crediting Method. Some (but by no means all) the crediting method terms you may encounter are:

  1. Daily Average
  2. Monthly Average
  3. Monthly Point-to-Point
  4. Annual Point-to-Point
  5. Inverse Performance Trigger
  6. Biennial Point-to-Point
  7. Three Year Monthly Average

You may encounter all of these terms in any given contract, and how they are calculated will vary from one carrier to another.  In addition, rates work together- a crediting rate  will be subject to a cap or participation rate, for example.  We’ll explain each below in a moment.

Why So Many Different Annuity  Rates?

Its important to note that all these rates, caps, and controls are designed by the insurance companies and their regulators to give a reasonable rate of return to the investor, and to help ensure the solvency and stability of the carrier.

Carriers do have to make money after all, and that’s not a bad thing, because first and foremost you are buying insurance for your money with an index annuity! The annuity guarantee  is only as strong as the issuing company, so it’s prudent to work with the strongest companies.

Annuity-haters love to complain about cap rates and participation rates, saying carriers are ‘taking’ market gains from you.  Well, this is just an ignorant comment.  Just because an index yields X% and you get something less than X% does not mean the carrier got the difference… and don’t forget the carrier is guaranteeing you’ll never lose your principal!

Most money managers can’t beat the S&P index anyway despite their smug commentary, and I have never heard a money manager offer a guarantee that you’ll never lose money.

With that said, let’s dive in.

Crediting Rate & Crediting Method

The crediting rate is the rate at which interest is credited to your account.  Here is a simple example of  an 80% crediting rate:

If the underlying index moves up 10% in the time period and you have a 80% crediting rate, you would receive 8% credited to your account.  If you started with $100,000, you would have $108,000 at the end of the year.

Remember too that the interest credit to your account will be locked in when credited, and the index value is reset as well.  That means that in year 2, if the market falls 20% and you have no interest credit, you still have your $108,000 at the start of year 3.

And it also means that your new starting point for the index itself in contract year 3 is the low end point of year 2… so you have your full protected account value, but are now deployed and ‘catching the dip’ in the market in year 3.

Even though you got 0% interest credit in year 2, you suffered no loss of principal and no loss of prior gains, and that is very powerful when you catch the rebound.

Understanding the Crediting Methods

Tightly related to the Crediting Rate is the Crediting Method.    Crediting method terms you may encounter are:

  • Daily Average
  • Monthly Average
  • Monthly Point-to-Point
  • Annual Point-to-Point
  • Inverse Performance Trigger
  • Biennial Point-to-Point
  • Three Year Monthly Average

Let’s expand the simple example from above with these new terms.

Using an annual point to point crediting method and an 80% crediting rate, and a year over year gain of 10% on the underlying index, you will receive a credit of 8% to your account.

It is important to note that there is no such thing as an overall “best” crediting method or index. Each of the crediting methods perform differently in various market scenarios and on different indexes. There is not one particular index or method that performs better than another when observed in all market scenarios.

Most investors allocate their principal to several crediting methods and indexes within an index annuity, to balance the pros and cons of each, and re-balance annually.

Daily Average Crediting Method

The daily average crediting method uses an average of the end of day market index values during the contract year to determine the change in the index.  The change in the index may be positive or negative, but only a positive change would be used to calculate your interest earnings.  If the index change as calculated using the daily average crediting method is positive, the final interest credited to your account may then be subject to a cap and participation rate.  Once interested is credited, it is ‘locked in’ and the account plus prior year earning grow in the next contract year.

By way of example, assume a market index started at 1000, rose to 1500, then fell back to 1000.  Calculating using the daily averaging strategy results in a 5% index gain.  5% would then be used to calculate interest credits to your account, which may then be subject to cap rates, participation rates, or other controls.

Note, the daily averaging strategy captures that mid-year rise, whereas an annual point to point strategy would not.

Monthly Average & Three Year Monthly Average Crediting Method

As the name suggests, it’s similar to the daily strategy but instead of using daily data points, it uses monthly data points across one year or three years to calculate the average index values.

Monthly Point to Point Crediting Method

The monthly point to point strategy takes the index gains and losses into account each month.  This strategy is typically tied to a monthly cap rate as well.  Index gains up to your cap rate, and losses also, are summed up at year end.  If the sum of the monthly points is greater 0%, that is your interest credit for the year.

As an example, if the index moves up 5% in one month and your have a 3% cap, that month’s gain will be 3%.  If the next month it moves up 1.5%, you have 1.5%.  The third month it moves down 3%, your month’s number would reflect -3%.  The sum of these three together is 1.5%.  Carry this on for the rest of the year, and at year end, you’ll get the monthly point to point interest credit amount.

Annual Point to Point and Biennial Point to Point Crediting Method

Similar to the example above, but using annual or Biennial markers instead of monthly markers.  The annual point would be your contract date, not 12/31 of any given year, so the index value on any given year may be up or down on your contract anniversary date.  If it’s up on that day, that is your interest credit for the year, subject to any other cap and participation rates.

Annual point to point is one of the simpler crediting methods to understand.

Inverse Performance Crediting Method

Think of the inverse performance crediting method as a market short position.  If the market is at 0% or down in the selected time period, you would receive a ‘Declared Rate’ which is like the fixed account yield, typically in the 3-4% range.

If you are particularly bearish on a market index and want to profit by its fall with a portion of your annuity account value, you could allocate to this strategy to pick up a yield in a bad market.

Now, with crediting methods out of the way, lets turn back to rates.

Cap Rate

The cap rate refers to a cap, or ceiling, on the interest credit to your account.  Depending on the crediting method of the indexed annuity contract, there may be a maximum gain, or cap rate, that limits how much you could earn.

When the underlying index performs well, you may butt up against a maximum gain the insurance company will credit. Cap rates generally run from three percent to nine percent.

To continue with our example

Using an annual point to point crediting method and an 80% participation rate, and a year over year gain of 10% on the underlying index, and subject to a 6% cap rate, you will receive a credit of 6% to your account.

Participation Rate

Participation rate refers to the amount of an index’s gain that a contract owner will participate in.  The insurance company will credit interest at this participation rate at the contract anniversary.

Depending on the carrier, this can be very similar to the Crediting Rate described earlier

Using an annual point to point crediting method and a year over year gain of 10% on the underlying index, at an 80% participation rate, you will receive a credit of 8% to your account.

Spread, or Margin Rate

Something you might see in close proximity to the Participation Rate would be a spread or margin.

The spread or margin rate are synonymous terms that refer to the first portion of gain that would not be credited to your account.  It’s typical to see from 1.5 to 2.5% spread, and the contract marketing materials would read something like this:

All New Index Annuity with Uncapped Strategy & 100% Participation!

  • Index gains are first subject to 2.5% spread prior to interest credits

In the example above, if the index moves up 8% in the year, your ‘un-capped’ strategy would result in a 5.5% interest credit, because the first 2.5% of gain is the ‘spread’ that is not credited to your account.  Said differently, in a year with a 3% index gain, you would receive only .5%

Always look at the fine print!

Guaranteed Minimum Rate

The Guaranteed Minimum Rate is often overlooked but really is one of the most important rates in an index annuity contract. Here’s why:

Wise people say “Buy the annuity for what it WILL do, not what it MIGHT do.”

Well, the guaranteed minimum rate is exactly that.  typically around 1%, this minimum rate is applied to your account value in years when the index performed badly and there are no gains to credit. It’s a consolation prize, a token interest income from your checking account, but it’s better than nothing.

If you want a totally bearish look at an illustration, look at the minimum guaranteed rate.

Rate Terms Unique To Lifetime Income Annuities

There are a couple of terms unique to lifetime income annuities to be aware of.  You may encounter these in index annuities with income riders, or in immediate annuities.

Roll-up Rate

The roll-up rate refers to the increase to the benefits base on an index annuity with income rider contract.  A typical example would be this

You invest $100,000 in an index annuity with income rider with a 10% bonus rate and an 8% rollup rate.  Your income account starts at 110,000 , and at the end of year 1 the income account would be 118,800 (110,000 * 1.08)

Payout Rate

In an index annuity with income rider, the payout rate determines how much money will come out of the income account value each year.

With a 6 percent payout rate on an income account value of $200,000, the payout would amount to $12,000 per year in income.

The payout rate is relatively straightforward- the tricky part is to understand the relationship between the income account and the actual account value.

Income payments are taken from actual account value, but the amount of income uses the payout rate and the income account value for calculation purposes

This is a critical distinction. The income account value is an imaginary number conjured up by the insurance company to understand how much they will pay their annuity contract holders each year.

With immediate annuities, the payout rate is more simple to understand- you invest $100,000, and at a 6% payout rate, you will get $6000/ year for life.  There is no ‘account value’ or ‘income account’ distinction.

Bonus Rate

Bonus rates are found in index annuities with income riders and are applied to the income account value. It is not actual money, and there are frequently vesting schedules involved with bonus rates.

Some contracts have a bonus rate that may be applied to the account value, but it comes with even longer vesting schedules and surrender penalties. We used the bonus rate in a prior example:

You invest $100,000 in an index annuity with income rider with a 10% bonus rate and an 8% rollup rate.  Your income account starts at 110,000 , and at the end of year 1 the income account would be 118,800 (110,000 * 1.08)

A bonus rate may also be termed as a premium bonus.  As mentioned, this is typically a bonus to the income account, however, there are contracts that apply the premium bonus to your actual account value, but subject to a vesting schedule. Indexed Annuities with premium bonuses may also include lower participation rates and cap rates versus those annuities with no bonuses.

Besides this, some of the insurance companies will only pay out these bonuses when the annuity holders annuitize in the future. For those who elect to withdraw the principal in one lump sum amount before the surrender period ends, the premium bonus may not apply.

Again, check the fine print and let us help.

Market Value Adjustment (MVA)

An additional term you may encounter in an annuity contract is an MVA or “Market Value Adjustment.”

Market value adjustments are associated with the surrender schedules and applied only if you decide to cancel a contract.  Basically, it looks at the interest rates applicable at the time of surrender to determine the total surrender penalty.  It’s a calculation that you can’t do today as it depends on rates in the future and only applies if you surrender.

If you are buying a contract with the intent to surrender the contract, don’t buy it at all!  And if you are buying it with no intent to ever surrender it, the surrender schedule or the MVA provision shouldn’t matter that much

But if flexibility and liquidity are strong concerns, and you think you might need access to your money in excess of the free withdrawal provisions of the contract, then the surrender schedule vs the MVA needs to be discussed.  Again, Contact Us to get expert assistance.

Growth Oriented Index Annuities

using fixed indexed annuities

Utilizing index annuities as a safe growth tool in your portfolio is at once a simple and a sophisticated concept.

Index annuities are designed as safe investment vehicles that protect and grow money, insulate from market volatility, and give you options in your retirement portfolio.  These benefits are simple to understand and convey.

It gets sophisticated when you look at the index annuity in the context of your overall financial portfolio.  Many retirees who research their options quickly realize that a low cost, high quality index annuity is superior to bonds for a safe-money or fixed income allocation.  This is a concept we explore further in our page on Index Annuities as Enhanced Bonds, and will touch on in this page also.

But before diving in too deep, lets understand that there are two main goals that people look to accomplish with index annuities.  They are growth, and income.

Index Annuities for Income

Using the index annuity contract as a base and adding a lifetime income rider is a popular product design choice for insurance companies, and it’s a popular product for agents and consumers as well.  But permit me to focus another page on index annuities for lifetime income, because it’s an expansion of many of the topics covered on this page, and to put them both together on one resource would be an awfully long read.  Lets stay focused.

Using Index Annuities for Growth

It’s important to first understand the key benefits of a growth oriented fixed indexed annuity, because if these are not things you need, there’s no need to read more:

  1. Capital appreciation
  2. Capital preservation
  3. Liquidity options
  4. Protection from volatility

There are over 400 different index annuities on the market today, and each has a design tweak, or a feature, or a calculation methodology geared to a specific goal.  It can be difficult to distinguish differences between contracts from various carriers, and it can even be a challenge to differentiate contract variations from the same carrier.

Therefore, it’s imperative that you have a good idea of your personal goals, time-line, and retirement income needs, before selecting a product.  (Incidentally, that’s the process we follow when you make an appointment with us at DCFAnnuities.com… )

Benefits of  Index Annuities for Growth

Forbes Magazine argues the main benefits of a fixed indexed annuity are to safeguard assets from two problems:

  1. Protect from volatility
  2. Provide  a safe rate of growth without risk of loss

Indexed annuities accomplish these two goals through their indirect investment in the markets- your principal is never at risk, but the yield is tied to appreciation in a stock market index.  Among these are the NASDAQ, the DOW JONES, and the S&P 500, as well as several proprietary and esoteric measures of performance.

Bottom line, insurance companies tie the yield on your annuity contract to the performance of an outside index, and offer you a guarantee of your principal so your money does not lose value.

Index Annuity Life Cycle

There are actually four stages in the life cycle of a fixed index annuity. They are as follows:

  1. Buy in – the first step is the purchase, where your premium is taken in and invested by the carrier in their fixed account holdings, like bonds and real estate mortgages, and other safe assets.  Commissions, distribution costs, and riders all impact the net amount of money the insurance company has available to invest.
  2. Accumulation Stage – in this stage, the invested premium earns the general account’s fixed interest credit.  It’s always an option in a fixed index annuity to take this fixed account yield, however many contract holders focused on index annuities for growth instead elect to allocate their account to one or more index – linked performance measures, to earn a higher level of growth if the underlying outside index grows.
  3. Growth on a Tax Deferred Basis – Fixed index annuities grow and accrue tax deferred, so year over year, your account value grows and compounds without the erosive force of taxes.
  4.  Distribution Stage – In almost all contracts, account holders have the option for partial withdrawals without any penalty every year. Investors using index annuities primarily for growth will be satisfied with the free withdrawal provision for liquidity on an as needed basis.  However, in addition to free withdrawals, there are of course index annuities with income riders that give longevity protection and options for lifetime income, though these may come with fees.

When using index annuities primarily for growth, the investor should be focused on the most efficient contracts for these various stages.  In other words, don’t buy an income rider if you are allocating primarily for growth…. and if growth is the #1 goal, make sure the contract you buy has index options and crediting methods that give you the most accumulation

The idea is to deploy your safe- money allocation into an indexed annuity in place of bond holdings, but do so in a way that maximizes growth without risk of loss to your principal.

Using Index Annuities as an Alternative to a Bond Allocation

One of the principal advantages of a high quality, low cost index annuity is an alternative bond allocation within a retirement portfolio. Bonds carry interest rate risk, lower yield, credit concentration risk, and price sensitivity to yield, but an index annuity addresses each of these negatives.  Be sure to read our page on index annuities as enhanced bonds for more details.

Who Buys Index Annuities for Growth?

In addition to a safe allocation alternative to bonds, index annuities are a compelling safe growth option.  A recent Allianz study found that 2/3 of retirees fear running out of money more than death itself.

Using high quality and low cost indexed annuities for safe and steady portfolio growth is the perfect way to ease the fear of running out of money.  Your principal is invested in safe assets, but wrapped with an insurance company guarantee against loss, and your earnings grow and compound tax deferred.  Growth is locked in each year and can’t be clawed back.

Investors most interested in growth oriented index annuities appreciate the value of the guarantee of principle protection, and understand that annuities offer a reasonable rate of return in light of the safety and guarantees. They may be individuals who typically like bonds or stocks, but who want the security that comes with knowing the integrity of the portfolio principle is assured.

NAFA has sponsored an academic paper written at Wharton on the subject of Index Annuity returns over the past few decades. This is called “Real-World Index Annuity Returns.” For investors who want to better understand how these particular annuities have fared in the real world since their inception, this is the paper to study.

Pros and Cons of Fixed Index Annuities for Growth: Pros

It is important to remember that any financial product’s pros and cons are intimately tied to the individual using the product.  The product may not be bad in and of itself… but it might not be right for you.  So take the pros and cons in the context of how an individual uses the contract, and look at how well this form of annuity will assist in meeting your own goals.

The advantages to the fixed index annuities as a growth tool are as follows:

  • Principal protection from stock market volatility – whether or not the stock market rises or falls, these annuities benefit from complete principal and credited earnings protection.
  • Guaranteed control over future income – with a Fixed Index Annuity, the contract owner has the security of knowing their principal is safe, and can turn it into income at any time in the future.
  • Tax-deferred growth – this product benefits from tax-deferred advantages as it gains in value and grows. Income taxes will not be due on any of the gains until distributions are taken.

Pros and Cons of Fixed Income Annuities for Growth: Cons

There are also some downsides to purely growth oriented fixed index annuities.  Again, these are largely situational and personal. These include the following:

  • Surrender periods – agreeing to a contract which will tie up the principal for from years to a decade or more is a choice that is not appropriate for all individuals. For some people, the annual free withdrawal period will not be sufficient to meet their needs.
  • Complicated crediting methods – while fixed index annuities are less complicated than some competing annuity contracts, the sheer numbers of choices, strategies, and available options make the product more complicated than some other investment alternatives. Consumers who start out in the weeds looking at the range of options too often give up in confusion.  Be sure to first establish the goals, and then decide if this product will meet those goals, before looking at the details.
  • Tax complications – while fixed index annuities benefit from tax deferment, taxes will eventually be due when income or distributions are taken.  Annuities are taxes as ordinary income as well, but investors should consult with their tax professional before simply moving money around.

Final Thoughts on Using Index Annuities for Growth

There are many benefits of growth oriented fixed index annuities. They offer principal protection, reasonable yield, safety, and flexible withdrawal options. Get in touch with us to help identify your goals and the find the best options. We are here to help.

Today’s Best Fixed Index Annuities

need a data feed of annuityratewatch or other table way to showcase a few selected ‘best of best’

Fixed Index Annuity Calculator

Income Oriented Index Annuities with Income Riders

income oriented fixed index annuities

The addition of income riders to fixed index annuities expands the functionality of the safe and steady accumulation platform into a single tool that offers elements of safety, growth, AND income.

It also creates the opportunity to use the same products for Income Now, or for Income Later.  Your mileage will vary greatly based on your needs and the product selected, which is why it’s critical that you talk to us to ensure you’re seeing the right tools for the job you need done.

Index Annuities With Income Riders Are Also Known As Hybrid Annuities

Fixed Index Annuity Road Map

In recent years, the term ‘Hybrid Annuity’ entered into marketing materials as these contracts are a hybrid of benefits and features.

Just remember, though, that a Swiss Army knife is a hybrid also- there’s a saw, a knife, a toothpick, and a corkscrew and 57 other features.  If you want everything in one package it’s great… but if all you need is a stout sharp knife, you’re sacrificing quality for a quantity of extras you don’t need.

Often, index annuities with income riders end up like a big clunky Swiss Army knife, which is why when you contact us we’ll start our conversations by making sure we both understand what you need, before looking at contracts, options, features, and riders.

That said, there are attractive elements of many of these contracts, as they can alleviate the key fears of many retirees.  People are attracted to index annuities with income riders as they do truly provide:

  1. Safety of principal, guaranteed by the issuing carrier
  2. Potential for growth of principal, through the market index and crediting methods chosen
  3. Lifetime Income, for the contract holder or a couple based on joint life 
  4. Flexibility and liquidity options, but subject to contract terms and surrender schedules 
  5. Additional disability and death benefits, depending on the contract

They truly do give that peace of mind of knowing you can never outlive your income… but when you do the math, to get the value out of the contracts you need to draw the income and live a long time.  When buying an index annuity with an income rider, you should consider it a lifetime commitment.  Surrendering contracts can be costly and the income values take time to accumulate.

With that overview (and, admittedly, a little bit of bias) out in the open, lets dive into the specifics of these contracts.

Brief History of Fixed Index Annuities and Income Riders

Annuities originated in Roman times. The name itself has its root in the Latin “Annua” meaning annual stipend, often paid to Roman soldiers in compensation for their service.

Over time, traditional annuities evolved into pure income contracts. They are frequently described as the opposite of life insurance. With life insurance, you pay a periodic premium for the carrier’s promise to pay your heirs a lump sum if you die.  With the simplest form of a lifetime income annuity, you pay the carrier a lump sum in exchange for the promise to make monthly payments to you as long as you live.

Annuities filled a small financial niche for hundreds of years, but growth picked up after the 1929 market crash.  Variable Annuities entered the marketplace in 1952, and the features and permutations have increased exponentially ever since.  The lines have blurred between the traditionally pure income contract structure and newer contracts with investment features like accumulation.

The year 1996 saw the introduction of Fixed Index Annuities. As we’ve discussed on other pages about fixed indexed annuities, the name itself indicates that it is a fixed yield contract whose gains are re-invested in an index strategy.

Fixed index annuities are a known as a safe accumulation contract as they may go up in value with market growth, but won’t go down. The addition of an income rider turns them into a multi purpose tool for safety and income.

How Income Riders Work

There are many different variations of income riders which we’ll describe in a moment, but first lets understand the basic structure.

With any income rider you will have an additional calculation column for an income account in addition to your actual account value.

Your account value– your invested premium and any gains- is real money that you can withdraw.

The ‘income account’ is not real money.  It is just a baseline from which the carrier calculates income payments made to you.

Carriers will use a variety of terms for this income account- withdrawal base, benefit base, income account, income base credit, income calculation base- but all mean essentially the same thing.

Here’s a quick and very simple example-

You invest $100,000 in an index annuity contract with an income rider.

The income account ‘rolls up’ at a rate of 8% per year, and your actual account is invested in a market index strategy.

During the first year, the index crediting method you selected resulted in a 5% gain to your contract.

At year end, your account value is $105,000 and the income account is 108,000.  The payout rate would be applied to the income account, but income drawn comes out of your actual account.

Note, there is no “$” on the income account. It’s not real money.

The Main Components of Income Riders

No matter what the name or the specific details of the income rider, the performance is driven by three main components, and an occasional fourth element:

  1. The Rollup Rate
  2. The Time Period
  3. The Payout Rate 
  4. The Bonus Rate

The Rollup Rate refers to the rate of increase to your income account.  This is the flashy rate you see advertised in misleading ads promising an “8%  Annuity”.  While not exactly dishonest, these sorts of ads are misleading as most consumers think they are earning 8%, but they are not.

A misleading but common annuity ad highlighting the income account rollup rate, not your actual account value.

In our earlier simple example, we used an 8% rollup rate.

The Time Period is self explanatory- how long you let the income account base roll up.  Different carriers have different methods- some offer a simple interest 10% rollup rate which is advantageous for time periods less than 7 years… others offer compounding rollups, which are in your favor over longer rollup periods.

How long do you plan to let this contract ‘season’ before taking income? In our prior example, we showed 1 year.

The Payout Rate is a percentage of the income account that is used to determine your income when you turn on your income rider.  Again, different companies have different provisions, but in general, the older you are, the higher the payout rate.  4% to 6% is typical, with slightly lower payouts for joint life contracts.

An important note, while the payout rate is applied to the income account to determine your income (eg, 5% of 108,000 from our earlier example), the income payment is drawn from your actual account value.  This would be $5400 taken from your account value.

The Bonus Rate is another term you will see on some index annuities with income riders.  Usually this is a bonus amount tied to the income account base- eg, a 10% bonus and 8% rollup.

If there were a 10% bonus on the prior example, your $100,000 investment would post as a 110,000 opening value to the income account, and at the end of year 1 the income base would be 118,800 (110,000 * 1.08).

Many carriers use bonus rates to attract premium, but often the bonus comes with additional vesting schedules and may come with longer surrender schedules as well.  Be wary of making decisions on bonus alone.

Putting the Income Rider Pieces Together

These three main components plus the bonus rate all work together to determine your income from a contract.  Some contracts are optimized for certain deferral time periods, like 5 to 7 years, others better at 10 years.  Some contracts continue to roll up after taking income, others do not.  Some have flashy and eye catching bonus rates, but often that is a smokescreen to cover up other less attractive terms.

Because each income rider is slightly different, it’s critical to work with a professional who can assist you understanding your needs first.  Too often, investors are first exposed to income rider annuities at dinner seminars and other ‘pitch’ events, without any discussion of needs.  At first glance, all the features and benefits of these contracts may sound essential in retirement, but perception and reality often differ.

Are Income Riders Bad?

It’s very hard to say if a particular contract is good or bad because so much depends on your situation, your needs, and timeline.  So instead of asking if it is ‘good or bad’, ask if it’s appropriate for you.

In most situations, you should approach the purchase of an index annuity with an income rider as a lifetime commitment. There are significant surrender penalties with these contracts, and the rollup rates usually take several years to gain in value.

You should not look at index annuities with income riders as very efficient growth tools- income riders have fees attached, usually 1%… Sometimes this is 1% of the account value, sometimes it’s 1% of the benefit base and taken from your account value.  Either method is a drain on performance.

In nearly all illustrations and past market scenarios, the income value grows in excess of the account value. When this happens, it makes a surrender decision much more difficult 5-10 years into a contract, because the income benefit may be significant and yet you may not need the income.  If you have years of poor actual account performance coupled with fees, you may have with little actual capital in the account value.

Clearly knowing your needs before buying the contract helps avoid this problem, and furthermore, if you’re not completely sure of your needs, using other safe contracts that provide more flexibility might be a better option.  Index annuities with income riders are great tools for a specific job- just make sure it’s a job you need done!

Pros of Fixed Index Annuities With Income Riders

There are many advantages to index annuities with income riders . These are as follows:

  • One Stop Shopping – Fixed Index Annuities and their Income Riders allow for a single-stop shopping
  • More than just security – They cover income security, potential for growth, and longevity protection all in one product
  • Access and control – While annuity holders enjoy a lifetime income guarantee, they also keep both access and control to the principal invested in the annuity
  • Dependable and stable income levels – Even if principal goes up or down (given interest rates and equities markets) the income level will not decline
  • Superior retirement planning possible – With lifetime income secured, pressure on other retirement assets is relieved.

Cons of Fixed Income Annuities With Income Riders

  • Complexity – Income riders unfortunately can be complex and difficult to comprehend
  • Performance – Don’t expect an index annuity to do all things well.  Account growth will be lower than pure growth-oriented contracts, and income may be lower than purely income focused options.
  • Hidden costs – Income riders carry fees and may be coupled with lower caps, participation rates, or spreads.

Final Thoughts on Fixed Index Annuities with Income Riders

It is important to remember that Fixed Index Annuities with Income Riders create two accounts. The one is the actual account value. The second is the separate benefits base that determines the income amount.

Income accounts may include bonuses and rollup rates but are not actual money. The actual account value may be subject to caps, spreads, and fees, as well as a surrender schedule

Income will be drawn from the account value, but is determined by the income base.  As a result, when you do decide to take income, you may be withdrawing from your account value at a fast pace.

Typical illustrations that roll up for 3 to 5 years then start drawing income show the account value to be depleted in about year 17 to 20 of the contract.  After the account value is depleted, income continues and is paid by the insurance carrier, so the contracts DO provide lifetime income and longevity protection.

Income riders are often confusing for would-be annuities buyers. Do not wait to have your questions answered. Call DCF Annuities today. We are here to help you make the best choice for your financial and retirement future.

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  • Schedule a 1-on-1 video call to discuss your specific needs and situation
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nathaniel pulsifer of dcf annuities

Nathaniel M. Pulsifer, Owner of DCF Annuities (800) 246-1932 | [email protected] | Linkedin

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What Are Fixed Index Annuities?

fixed index annuities

Fixed Indexed Annuities are safe and stable retirement investment annuities that provide investors with three primary benefits:

  1. Tax deferral,
  2. Market-based growth, and
  3. Principal protection

Fixed Index Annuities

It’s not often that you find something you can count on to go up, but not go down in value… but that’s exactly what an index annuity does.

And when you couple that protected growth with insulation from market volatility, you may find this to be one of the smartest things you can do with some portion of your retirement nest-egg.

These valuable retirement planning tools also go by the name of Indexed Annuities and Equity Indexed Annuities.  In addition, on another page, we explore index annuities with income riders that turn the index contract into an income vehicle.  These are sometimes called Hybrid Annuities, but on this page, we’ll focus on the inner workings of the baseline Fixed Index Annuity contract, how they work, and explore some of the pros and cons.

How Fixed Index Annuities Work

In a fixed index annuity, the insurance company uses your premium to buy safe and secure assets like bonds and real estate mortgages.  This is what insurance companies traditionally do in their ‘fixed accounts’ and it is this stable book of business that forms the underlying yield in core insurance products like fixed annuities and cash value life insurance.

But unlike in a fixed annuity or a life policy where you’re credited with earnings from this fixed account once a year,  with a fixed indexed annuity, the insurance company uses the earnings from that fixed account to buy participation- typically through an options strategy- in a market index.

With option participation in the market, if the market goes up, the options are ‘in the money’ and a gain is realized.  If the markets tank, all that is wagered is the option consideration.

So you can see in the name ‘fixed indexed annuity’ it is a fixed yield underlying contract whose gains are re-invested in an index strategy.

You can also see how the insurance company can make the promise that your principal will never go down in value- because the principal is always invested in ultra-safe assets, the insurance company can guarantee no losses on that money.  It’s only the earnings that are at risk.

And finally, as it is an annuity under US tax laws, the growth of a Fixed Index Annuity will defer, compound, and grow upon itself tax-deferred until it is taken out.

Growth Rates on Fixed Index Annuities

The rate of growth credited to your contract is calculated (sometimes by complex formulas) based on the performance of a market index. The most common index is the S&P 500 or the Dow Jones Industrial Average (DJIA), but there are hundreds of varieties, linked to everything from gold indexes, to foreign markets, to esoteric and proprietary indexes.

Measuring growth rates, comparing indexes, and understanding crediting methods, caps on credited growth, and participation rates in growth, is broad and complex topic that we’ll explore in a moment on this page, as well as other pages on this site dedicated to fixed index annuities.  Suffice to say that it can be challenging to draw apples to apples comparisons between contracts and carriers.

Who Buys Index Annuities?

The primary buyer of a fixed index annuity is seeking to ‘take some money off the table’ by protecting assets.  In fact, one of the better strategies is to use a fixed index annuity as a bond alternative. Here’s the logic- bonds produce a stable yield but carry interest rate risk to the principal and credit risk of default… Why not substitute your bond holdings with a high quality, low cost index annuity which has principal guarantees and a reasonable rate of growth?

In addition, another typical buyer is looking for respite from market volatility.  The ups and downs of the stock market are particularly painful in the years leading up to retirement, and during retirement, a bad swing in the markets can take away years of comfortable retirement income.  Removing volatility from your portfolio builds retirement security.

Another typical consumer of fixed index annuities seeks income.  In reality, the ultimate point of all investment activity is to produce income. How best to turn your accumulated investment portfolio into income? That is more of a timing question than anything, and using safe and secure index annuities will give you time, with protected principal, to pick an advantageous moment to withdraw for income, or to annuitize, or to acquire a more efficiently pure income annuity, like an immediate annuity.

It should be noted that there is a booming trade in ‘silver bullet’ index annuities that combine safety, growth, and lifetime income all into one contract.  These are at times marketed as ‘hybrid annuities’ and like any jack of all trades, they really are the master of none.  You’ll get marginal account growth, and when you do the math, you may need to receive income far beyond typical life expectancy to realize a decent yield.  There are better ways to turn your assets into income than these ‘do it all’ type hybrid contracts.

How Does Interest Get Credited?

Interest crediting in index annuities is done in a variety of ways.  Fundamentally, it works like this- as the value of an underlying index increases, some portion of that gain will be credited as interest to the account holder, on a timeline and according to a formula.

The interest rate can never be negative, even when the market declines. And especially important is that interest that has already been credited to the value of the account can not be lost to a market downturn.

That was easy to say… now for the fine print.

Index Annuity Crediting Methods

There are a range of formulas that insurance companies rely on for crediting these gains. A given annuity’s design will play a part in determining the method used to correlate the interest amount the insurance company will credit at the conclusion of an index term. The most common term is yearly, but there are monthly, quarterly, and multi-year options out there also.

Formulas for crediting the interest are compromised of two components. These are the crediting methods, and the controls or limiting factors.

Commonly employed crediting methods include the following:

  1. Monthly Point to Point – this method assesses the underlying index value’s percentage change every month. When the conclusion of an index term is reached, the noted percentage changes for each month will be compiled together. This includes negative and positive month changes.
  2. Annual Point to Point – this figures the underlying index percentage changes from one date to the closing date. This will be the start and finish of the year for the given annuity contract.
  3. Multiple Year Point to Point – this assesses the underlying index value percentage change from a beginning to an end date set over more than a year apart.
  4. Daily Averaging – insurance companies compare the value of the underlying index from the conclusion of the index term to the value of this same index on the index term first day. They use a daily average based on generally 252 trading days in this comparison.
  5. Monthly Averaging – like with the daily averaging method, this compares the index value from the end of the term to the beginning of the term. This method employs a monthly average for comparison.

Along with the crediting methods the insurance companies use, there are also controls or limiting factors applied. The end result of this is that total interest earned will be restricted to only a part of the gains in the underlying market index throughout the index term. The insurance companies explain this limitation as the price paid for the contract owner obtaining principal guarantees of protection.

Typical Limiting Factors include all of the following:

  1. Participation Rate – this specifies the percentage in any increase (to the relevant market index) that the insurance company will utilize in compiling interest credit from the term (on gains linked to the index).
  2. Cap Rate – this limiting factor is the maximum participation that the contract owner can benefit from on all interest rates. In other words, it is a maximum total interest rate for a given term.
  3. Margin or Spread Rate – a predetermined percentage that the insurance company will subtract from the calculated gains in the underlying index, this decides what the net amount of interest credited to the contract can be.

Pros and Cons of Fixed Income Annuities


Fixed Income Annuities come with many advantages. These include the following:

  • Guaranteed Earnings – the greatest positive factor to Fixed Index Annuities is the guaranteed principal that includes the possibility to make additional gains from appreciation in the stock market.
  • Interest applied – to the annuities account similarly can not be lost regardless of what volatile markets are doing.
  • Security – thanks to the promise of the insurance company that principal can not be lost, contract holders can sleep easier at night. Not only does this guarantee come from a safe investments’ portfolio held by the account, but the insurance company also backs it with significant assets and cash reserves.
  • No lengthy surrender period – with bonds and CD’s, long term commitments become mandatory in practice. Annuities include both elimination of interest rates’ risk and accessibility to the funds.
  • Participation in stock market upside potential without any downside – means that yields in a guaranteed investment can be significantly greater than other safe assets. These Fixed Index Annuities are really no-risk means of benefiting from stock market index performance.
  • Variety of underlying indices – there are many underlying indices that contract holders can select from, as well as methods of interest crediting. It makes the Fixed Index Annuities market something like an all you can eat buffet from which investors can simply pick the options that suit them best.


As with any realistically portrayed investment, there are potential downsides to Fixed Index Annuities. They are not right for every individual’s needs. The disadvantages to Indexed Annuities include the following:

  • Withdrawal limited to an annual basis – the withdrawal provision generally allows for a single free withdrawal per year, which means that it gets expensive if an unforeseen need arises requiring additional principal liquidity.
  • Interest crediting limitations – this comes down to the value of the index and market on a given day on which the insurance companies fix the comparison date. In other words, if the market suffers a substantial decline near the conclusion of the index term, then gains for possibly the entire year can vanish.
  • Limiting factors are restrictive – growth in these contracts is limited by the appropriately named limiting factor.

The Importance of Free Withdrawal Provisions in the Annuities Contract

A final consideration is the beauty of free withdrawal provisions in such a Fixed Index Annuity contract. Because a contract holder can simply use a free withdrawal opportunity once a year to take out what he or she needs, this makes the tool an extremely effective and great safe money planning strategy. These particular annuities are often more lucrative, efficient, and flexible than alternatively utilizing Index Annuities with Income Riders.

We are always happy to answer any questions that you may have on these and other types of annuities. For more information on Fixed Index Annuities, please contact DCF Annuities.

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nathaniel pulsifer of dcf annuities

Nathaniel M. Pulsifer, Owner of DCF Annuities (800) 246-1932 | [email protected] | Linkedin

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