The index annuity has several moving parts which can have an effect on the return. It is important for the owner to understand these parts, how they move and the effect they can have on an annuity. The moving parts consists of caps, asset fees, participation rates and methods of interest crediting.
The cap is an upper limit that will be credited to the policy. The cap may be the only moving part in some annuities. Sometimes it is used in conjunction with a participation rate. For example, if a policy earns 14% but has a 10% cap, only 10% will be credited to the account.
2. Asset Fees
The asset fee also known as the margin spread is used to subtract a contractual percentage from the change in the index. If the index has a gain of 14% and the contract has a 2% asset fee, the amount credited would be 12%. The asset fee is used only if the index gain is larger than the asset fees. Most life insurance companies do not use asset fees in their contracts.
3. Participation Rates
The participation rate in the index annuity is a percentage rate as stated in the contract multiplied by the index gain. The rate is guaranteed in most contracts and always has a guaranteed minimum rate. The participation rate can be moved up or down by the insurance company usually only on each contract anniversary. If a policy has an index gain of 20% and a 75% participation rate, 15% will be credited to the interest account. http://web-software-design.com/web-design.html
4. Methods of Interest Crediting
The amount of interest credited depends on the index term which is usually one year but can be as long as ten years. Some companies only pay simple interest during the indexing term while other life insurance companies allow interest compounding during the index term which allows already credited interest to earn interest in the current term and future index terms. If the policy is surrendered before the end of a term , some companies will not credit any interest earned for that term. Other companies credit the amount that is vested. As the policy nears the end of a term, the vested amount increase until it is 100% at the end of the term.
The moving parts of the index annuity reflect the actual costs incurred by the company and are used to maintain profitability and credit ratings. So it is absolutely imperative for a prospective purchaser to understand what moving parts are and their corresponding percentages in order to make an informed purchasing decision. The agent should explain the policy, show the percentages used in the policy and answer any questions. The index annuity sounds complicated but compared to other investments it is reasonably easy to understand.
Annuities are long term investments and they offer limited liquidity without surrender charges, so the owner should have an accurate understanding of their future liquidity needs. As an integral part of any retirement program, annuities offer very low risk and usually offer higher returns than CDs or money market funds. The next post will analyze how the annuity works and different indexing methods.