A fixed annuity is the simpler cousin of a variable annuity. You typically won’t see many exam questions on fixed annuities because they’re not considered securities. The key reason is that the investor doesn’t take on investment-related risk (for example, market risk).
With a fixed annuity, the investor’s contributions go into the insurance company’s general account (not a separate account). The insurance company invests those funds and guarantees a (typically low) rate of return (for example, 3%).
As compared to a variable annuity, fixed annuities come with clear trade-offs.
The pros: the money grows at a guaranteed rate of return, and the investor doesn’t need to worry about investment-related risks like market risk or interest rate risk. For conservative, risk-averse investors, this can be an appealing retirement option.
The cons: variable annuities may grow more over time (more risk, more return potential), and the fixed rate of return is especially exposed to inflation (purchasing power) risk. Any investment with a fixed rate of return faces this risk. If the prices of goods and services rise (in percentage terms) by more than the guaranteed rate of return, the investor is effectively losing purchasing power to inflation.
Equity indexed annuities (EIAs) combine features of both variable and fixed annuities.
EIAs are not considered securities, primarily because the investor doesn’t bear investment risk when the index declines.
Even though an EIA’s return is linked to an index (during the accumulation and distribution phase), the investor’s gains are usually limited. Insurance companies restrict returns in one of three ways:
Participation rate
An EIA with a participation rate credits only a portion of the index’s return. For example, if the S&P 500 returns 10% and the EIA has an 80% participation rate, the annuity would be credited with 8% (80% x 10%).
Cap (ceiling)
An EIA with a cap (also called a ceiling) sets a maximum return that can be credited. For example, with a 7% cap, the investor won’t be credited more than 7%, no matter how well the index performs.
Spread rate (margin, asset fee)
An EIA with a spread rate (also called a margin or asset fee) subtracts a stated percentage from the index return. For example, if the index is up 12% and the spread rate is 3%, the annuity would be credited with 9%.
An EIA may include any one of the above or a combination. For example, a participation rate and a cap may exist, but no spread rate. Or, a cap and spread rate exist, but no participation rate. Or, all three or just one. The combination of restrictions enforced depends on the contract between the investor and the insurance company.
In exchange for limiting index-linked gains, EIAs provide minimum growth guarantees. In particular, EIAs include a floor of at least 0%*, if not more. A floor is the minimum growth rate guaranteed to the investor. A 0% floor means the investor won’t be credited with a loss even if the linked index is negative. Some EIAs offer floors as high as 3%, which can produce consistently positive credited returns. However, higher floors are usually paired with lower caps and participation rates and/or higher spread rates.
*Test questions may not specifically mention a floor. You should always assume a floor of 0% exists if a floor is not identified.
Let’s look at an example together to see how these features work:
An investor contributes to an equity-indexed annuity with a 70% participation rate, 8% cap, and a 1% floor. The linked index returns a positive 10% return over the specified period just before the contract is adjusted. What return will be credited to the investor’s annuity?
A) 5.6%
B) 7.0%
C) 8.0%
D) 10.0%
Can you figure it out?
Answer = 7.0%
Start with the participation rate. The index returned 10%, and the contract credits 70% of that return:
Now check the cap and the floor:
Bottom line: the investor is credited a 7% return.
How the insurance company measures the index’s return is another important contract feature. For example, does the company measure the index from January 1 to December 31 and adjust annually? Or does it use the highest or lowest index value during a period? In general, these are the most common index crediting methods:
Annual reset
With annual reset, the insurance company compares the index value at the start of the period to its value one year later (often on the contract anniversary). For example, suppose the investor enters the contract on July 1, 2022 when the index is 4,000. On July 1, 2023 the index is 4,400. The 400-point increase is a 10% gain (400 / 4,000). After that, any participation rate, cap, floor, and/or spread rate is applied.
Point-to-point
Point-to-point works like annual reset, but the two measurement points don’t have to be one year apart. The period could be as short as a month or as long as a few years. Otherwise, the calculation is the same: compare the index value at the start point to the index value at the end point, then apply any participation rate, cap, floor, and/or spread rate.
High water mark
High water mark compares the starting index value (often the contract anniversary) to the highest index value reached during a specified period (usually a year). For example, suppose the investor enters the contract on July 1, 2022 when the index is 4,000. On July 1, 2023 the index is 4,400, but in March 2023 it reached 4,600. Under high water mark, the insurer uses 4,600 instead of 4,400. The 600-point increase is a 15% gain (600 / 4,000). Then any participation rate, cap, floor, and/or spread rate is applied.
Low water mark
Low water mark is essentially the inverse of high water mark. It compares the lowest index value during the period to the ending index value. For example, suppose the investor enters the contract on July 1, 2022 when the index is 4,000. On July 1, 2023 the index is 4,400, but in November 2022 it reached a low of 3,500. Under low water mark, the insurer uses 3,500 as the starting point and 4,400 as the ending point. The 900-point increase is a 25.7% gain (900 / 3,500). Then any participation rate, cap, floor, and/or spread rate is applied.
Sign up for free to take 10 quiz questions on this topic