index annuity rates and crediting methods

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 verses 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.