Now that you understand a variable annuity, we’ll briefly cover a fixed annuity. You shouldn’t expect many test questions on this product as it is not considered a security. This is because the investor does not face investment-related risk (e.g. market risk).
Instead of the investor’s assets being placed in their control within the separate account, a fixed annuity places contributions into the insurance company’s general account. The insurance company invests the funds on behalf of the account owner and guarantees a (typically low) rate of return (e.g. 3%).
As compared to a variable annuity, there are pros and cons. The pros - money grows at a guaranteed rate of return and the investor does not need to concern themselves with investment-related risks like market risk or interest rate risk. For conservative and risk-averse investors, this may seem like a suitable retirement option.
The cons - variable annuities may grow more over time (more risk, more return potential) and the fixed rate of return is especially subject to inflation (purchasing power) risk. Remember, any investment with a fixed rate of return is subject to this risk. If prices of goods and services rise more (on a percentage basis) than the guaranteed rate of return, the investor is technically losing money to inflation.
Equity indexed annuities (EIAs) share characteristics of both variable and fixed annuities. They provide returns linked to an equity index like the S&P 500, similar to a variable annuity. EIAs offer minimum guaranteed returns, similar to a fixed annuity. They are not considered securities primarily because investors do not face investment risk when the index declines.
Although the returns of an EIA are linked to an index (during the accumulation and distribution phase), gains obtained by the investor are limited. Insurance companies restrict returns in one of three ways:
Participation rate
EIAs including a participation rate only allow the investor to keep part of their linked index returns. For example, an EIA with an 80% participation rate connected to the S&P 500 in a year it returns 10% would only be credited with an 8% return (80% participation rate x 10% index return).
Cap (ceiling)
An EIA with a cap (a.k.a. ceiling) assigns a specified maximum return the investor may achieve. For example, an EIA with a cap of 7% would not credit more than 7% to the investor, no matter how well the linked index performed.
Spread rate (margin, asset fee)
EIAs containing a spread rate (a.k.a. margin or asset fee) perpetually deduct a specified percentage from the returns of the linked index. For example, an EIA linked to the S&P 500 while it is up 12% with a spread rate of 3% would only credit a 9% return to the investor.
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 return for restricting index-linked gains, EIAs provide minimum growth guarantees. In particular, EIAs include a floor of at least 0%*, if not more. A floor represents the minimum amount of growth guaranteed to an investor. While a floor of 0% may not seem superb, it essentially guarantees the investor will not experience losses should the linked index go negative. Some EIAs contain minimum growth rates as high as 3%, ensuring the investor will experience positive returns consistently. However, greater floors are usually coupled 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 better understand 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%
The participation rate should be the first feature considered. The linked index returned 10%; applying the 70% participation rate results in an initial credited return of 7% (10% index return x 70% participation rate).
The cap and the floor also must be considered. The cap represents the maximum credited return, regardless of how well the index performs. The initial 7% credited return is not above the 8% cap, so the cap does not have an impact. The floor represents the minimum credited return, regardless of how poorly the index performs. The initial 7% credited return is not below the 1% floor, so the floor does not have an impact.
Bottom line - the investor is credited a 7% return in this scenario.
How exactly an insurance company calculates the return of an index is an important feature for investors to be aware of. For example, are index returns calculated from January 1st to December 31st with adjustments being made annually? Or does the insurance company consider the highest or lowest value of the index during a specified time period? In general, these are the most common index crediting methods:
Annual reset
This crediting method is what it sounds like. At the anniversary date of the initial contract, the insurance company measures the difference between the index value at the starting point versus its value one year later. For example, assume an investor enters into a contract to annuitize their EIA on July 1st, 2022 when the linked index was at 4,000. One year later on July 1st, 2023, the linked index is at 4,400. The change in 400 points would result in a 10% positive gain (400 point increase / 4,000 starting index value). From there, any applicable participation rate, cap, floor, and/or spread rate would be applied.
Point-to-point
This crediting method is very similar to annual reset, but the two points used to determine the change in index value aren’t necessarily the anniversary date on an annual basis. The two points considered could be as short as a month or as long as a few years. Otherwise, it is essentially the same as annual reset.
High water mark
The high water mark crediting method compares the index value at the starting point (typically the contract anniversary date) to the highest point the index reached over a specified period (usually a year). For example, assume an investor enters into a contract to annuitize their EIA on July 1st, 2022 when the linked index was at 4,000. One year later on July 1st, 2023, the linked index is at 4,400, but in March 2023 the index reached a high point of 4,600. The high water mark crediting method would discard the ending value of 4,400 and instead utilize the highest index point at 4,600. Therefore, the 600 point change would result in a 15% positive gain (600 point increase / 4,000 starting index value). From there, any applicable participation rate, cap, floor, and/or spread rate would be applied.
Low water mark
The low water mark crediting method is essentially the inverse of the high water mark method. The lowest point of the index is compared to the ending index value to determine the amount credited. For example, assume an investor enters into a contract to annuitize their EIA on July 1st, 2022 when the linked index was at 4,000. One year later on July 1st, 2023, the linked index is at 4,400, but in November 2022 the index reached a low point of 3,500. The low water mark crediting method would discard the beginning value of 4,000 and instead factor in the lowest index point at 3,500. Therefore, the 900 point change (3,500 low point vs. 4,400 ending point) would result in a 25.7% positive gain (900 point increase / 3,500 low point). Like all other methods, any applicable participation rate, cap, floor, and/or spread rate would be applied from there.
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