What it means
In an indexed product the insurer does not invest your money directly in the market. Instead it credits interest by reference to how an index, such as a stock market index, has performed.
The method decides how the index change is turned into the interest added to your account. Several methods are common.
In annual point-to-point crediting, the index value at the start of the year is compared with the value at the end. In monthly averaging, the index is measured each month and the average is compared with the starting value, while monthly sum methods add up each month's change, usually with a cap on each month.
The insurer then applies limits. A cap is the maximum interest that can be credited in a period, and a floor, often 0%, means the account will not lose value because of a falling index.
A participation rate gives you a set percentage of the index gain, and a spread or margin is a percentage deducted from the gain before crediting. These features create a trade-off.
The floor protects the saver in poor years, but the cap, participation rate and spread mean that the saver gives up part of the upside in strong years. The terms can usually be reset by the insurer each year within limits set out in the contract.
Price changes in an index usually exclude dividends, so the credited interest may be lower than the total return on the underlying shares. Savers should also read how the method treats a year in which the index falls and whether partial years or withdrawals are handled differently.
Because the methods vary widely, comparing products means comparing the full set of terms rather than the headline cap. Two products with the same cap can credit very different amounts depending on the method used.
In practice
Real-world examples.
Example
A retired teacher places $200,000 in an indexed annuity with annual point-to-point crediting and a floor of 0%. In a year when the index falls, she is credited nothing but her balance does not drop.
Example
A saver compares two annuities, one with a 5% cap and another with a 70% participation rate and no cap. He models several index scenarios and finds that the better product depends on how strong he expects the market to be.
Example
A financial adviser explains monthly averaging to a client. She shows that in a year where the index jumps in the last month, averaging credits less than point-to-point because the early months pull the average down.
Formula
Calculation
Index gain = (Index at end - Index at start) / Index at start
Credited interest rate = the lower of (Index gain x Participation rate) and the Cap, but never below the Floor
An index starts the year at 4,000 and ends at 4,360, so the gain is (4,360 - 4,000) / 4,000 = 360 / 4,000 = 9.0%. With a participation rate of 80%, the gain becomes 9.0% x 0.80 = 7.2%. The cap is 6.0%, so the credited rate is 6.0%.
On a $100,000 account the interest credited is 100,000 x 0.06 = $6,000. If the index had fallen 10%, the floor of 0% would apply and the credit would be $0, with no loss of the original $100,000.Case study
Seen in the real world.
Oakmere Life is an illustrative, fictional insurer that sells an indexed annuity with three crediting options. A new customer, aged 60, had $150,000 to invest and could not decide between them.
The adviser modelled a year in which the index rose 12%. Annual point-to-point with a 7% cap credited 150,000 x 0.07 = $10,500, while an option with a 50% participation rate and no cap credited 150,000 x 0.12 x 0.50 = $9,000.
In a year with a 4% rise the second option would credit 150,000 x 0.04 x 0.50 = $3,000, against $6,000 for the first. In this illustrative story, the customer chose the capped option and understood that she was trading some potential upside for a more predictable credit.
Watch out
Common mistakes.
- Assuming the credited interest equals the index return, when caps, participation rates and spreads usually reduce it.
- Comparing products on the cap alone, without looking at the crediting method and the other limits.
- Forgetting that insurers can often change caps and participation rates each year, which affects future credits.
Questions
People also ask.
What is a floor in an indexed product?
It is the minimum credited rate, often 0%, which prevents the account from losing value because of a falling index.
What is a participation rate?
It is the percentage of the index gain that is used to work out the credited interest, for example 80% of a 9% gain.
Does the account include the dividends from the index?
Usually not, because the index change normally excludes dividends, so credited interest can be lower than the total return on the underlying shares.
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