A Fixed-Indexed Annuity (FIA), like any annuity, is a contract between you and an insurance company. You pay premiums in a lump sum or periodically, and the issuer promises* to pay you some amount in the future. With a FIA, the interest earnings are tied to the performance of an equity index. The FIA issuer also provides a minimum guaranteed* interest rate on your premiums
paid. With a FIA, your interest earnings may increase if the market performs well, but if the market performs poorly, a portion of your principal still earns a minimum interest rate, according to the terms of the annuity contract.
Note, however, that any return, whether guaranteed or not, is only as good as the insurance company that offers it. Both the FIA’s principal and its earnings are entirely dependent on the insurer’s ability to meet its financial obligations.
The first FIAs that were introduced worked very simply; the interest rate was determined by computing the difference between the value of the index to which the annuity was linked on the annuity’s issue date and the value of the same index on the annuity’s maturity date. If the difference was negative (i.e., the market performed poorly and the value of the index decreased), interest was calculated using the minimum interest rate. If the difference was positive (i.e., the market performed well and the value of the index increased), the
interest rate used was a percentage of the difference–but usually not the
The participation rate determines how much of the gain in an index will be imparted to your annuity. Forexample, if the difference (i.e., gain) in the index is 7% and the participation rate is 90%, then the interest rate is 6.3% (90% of 7%). Participation rates of 70% to 90% are typical. Obviously, the higher the participation rate, the higher the potential return. However, FIAs have many features, some of which can offset a lower participation rate or other features. Keep this in mind when considering a FIA or making comparisons between
The indexing method is the approach used to measure the change in an index. The original method, which measures index
values at the beginning and end of the term, is known as the point-to-point or European method. Still used today, the
point-to-point method is the simplest approach, but it fails to consider market fluctuations that occur in between
the issue and maturity dates. This can result in unsatisfactory returns if the market declines at the end of the term.
Another approach, known as the high-water-mark or look-back method, looks at the value of the index
at certain points during the term, such as annual anniversaries. The highest value of these points is
then compared to the date-of-issue value to determine any gain to be credited to the EIA.
A third approach, the averaging method, also looks at the value of the index at certain points during the
annuity’s term, then uses the average value of these points to compute the difference from either the
date-of-issue value or the date-of-maturity value.
The fourth main indexing method is known as the reset or ratcheting method. With this method,
start-of-year values are compared to end-of-year values for each year of the annuity’s term. Decreases
in the index are ignored, and increases are locked in every year.
How interest is credited to an FIA
With some FIAs, no interest is credited until the end of the term. With others, a percentage of the interest is vested or credited
annually or periodically, which gradually increases as the end of the term nears. Further, some FIAs pay simple interest while
others pay compound interest. These features are important not only because they affect the amount of your return, but also
because having interest vested or credited to your FIA periodically instead of at the end of the term increases the likelihood
that you’ll receive at least some interest if you surrender your FIA before maturity.
Caution: Many FIAs have surrender charges, which can be a percentage of the amount withdrawn or a reduction in
the interest rate. Further, withdrawals from tax-deferred annuities before age 59½ may be subject to a 10% penalty.
Interest rate cap
Some FIAs put an upper limit on the interest rate the annuity will earn. Say, for example, that an FIA has an interest rate cap of
6%. If the gain in the index is 7% and the participation rate is 90%, the interest rate will be 6%–not 6.3%.
Some FIAs charge an asset fee, also known as spread or margin, which is a percentage that is deducted from the interest
rate. The asset fee may replace the participation rate or it may be added to it. For example, if the gain in the index is 7%, the
interest rate on an FIA with an asset fee of 2% will be 5%. If there is also a 90% participation rate, the interest rate will be 4.5%.
Tip: All of a FIA’s features should be clearly spelled out in the prospectus or other sales literature, and if you purchase the FIA,
in your contract as well