If you’ve been thinking about your retirement goals, chances are that you’ve encountered the term “index annuity.” You may have heard that there are various crediting methods that revolve around them. However, these lead to more questions than answers, and confusion can set in quickly if you don’t know where to look. In this blog post, we discuss what annuity crediting is, and how it works.
What Is an Index Annuity?
A fixed indexed annuity is a tool used to build up retirement savings on a tax-advantaged basis. These are becoming the more popular option for many retirees since it allows them to grow their money by protecting their principal against losses, earning interest, and providing a guaranteed stream of income during retirement without the risk of losing your principal. If you are interested in this option to help save for retirement, you’ll need to understand the crediting methods associated with index annuity — the means by which you earn interest with your annuity funds.
Fixed-indexed annuities will usually provide an option that pays at a fixed rate for a certain amount of time. While index annuity crediting methods are not guaranteed, they do offer potential growth that may rise above the fixed alternative without the risk of losing your principal. Moreover, fixed index annuities offer more potential growth for your money compared to other kinds of annuities.
The Components of Index Annuity Crediting Methods
- Participation rates
Participation rates refer to a different way that limits the growth that you can reap within a crediting period. Having a participation rate of 50% means that you’ll reap 50% of the underlying benchmark index’s growth, no matter how much that is. As such, this crediting method may result in higher overall growth throughout the life of the contract compared to one using a cap rate.
Spreads are another way that an insurance carrier can limit the growth of your indexed annuity, and would apply for a whole crediting period, like a full year. For example, imagine that the spread is at 2% while the index goes up 10% for that year. In this case, an insurance company would get 2% of the 10% growth. This can be particularly useful if the benchmark index for the year gains big.
Caps refer to the limits set on how much growth your money can achieve within a certain period under a fixed index annuity. An example might be a cap of 10% for the duration of one whole year. This means that the most annuity you can get for that year is 10% no matter how high the underlying index gets. Frequently, an insurance company will combine a Participation Rate with a Cap, which would look something like a participation rate of 50% with a cap of 10%.
Index Annuity Crediting Methods
Interest crediting methods determine how much interest will be accruedby your fixed index annuity (FIA). The method chosen for interest crediting will measure how much interest an annuity holder may get over a specific set of time. As mentioned above, annuity contracts will come with a number of factors that affect interest rates, but there are also crediting methods that we’ll discuss below. The three kinds of index annuity crediting methods include the following.
Annual Point To Point
This method refers to the most common and simplest crediting method for an indexed annuity, which looks at index values from two different periods. This could be a great option for minimizing the volatility that occurs in the middle of the year. In this method, index values at the beginning of a crediting period get taken away from the index value once the crediting period ends. If the index value is higher when the year ends compared to when the year started, one of the crediting components above will be applied to help calculate the value of your interest.
For instance, let’s say that there was a 7% index change, where we apply a cap of 5%, a spread of 2%, and a participation rate of 75%. Then the interests earned from these factors will be as follows:
- A 5% cap will earn you a 5% interest once the index changes along with the cap.
- A 2% spread will earn you a 5% interest once the index change is subtracted from the spread.
- A 75% participation rate will earn you a 5.25% interest once you multiply the index change by the spread.
As the crediting method that’s the most sensitive to volatility, monthly sums can provide great yields of interest in steady up-markets. However, it may be negatively impacted by big monthly decreases. Every month during your contract anniversary, the index value is used to compare with last month’s value, which is then used to calculate the percentage of change. By the year’s end, the monthly index will increase and the decreases are also added up.
While the increases come with a cap, the decreases don’t. If your monthly sum is positive, you’ll be able to get that amount of interest, but if the final monthly sum is negative, you will not receive any interest for the contract year.
Two-Year Point To Point
The two-year point-to-point crediting method uses two index values taken from two different contract years. This could be the right option if you’re looking to control the volatility effects that may occur between these points in time. To get the sum of this index annuity crediting method, the value at the start of that crediting period is taken away from the index value when the two years are finished. This is known as the second crediting period.
Next, the change percentage will be calculated. If you get a value higher in your second year compared to the start of your first period, one of the crediting components will be applied to calculate the amount of interest to be credited. Remember, each index annuity crediting method will have one or many limiting components that will help to determine just how much interest could be credited to your index annuity.
Which Index Annuity Crediting Method Is for You?
Unfortunately, there is no single “best” crediting method or option that works out better compared to the others in the long term. However, for a shorter period of time, some crediting methods may do better than others. Rather than looking for the best option, be sure to check for an index annuity contract with simple and straightforward index options and crediting methods.
This will make it easier for you to compare annuities and find the right annuity for you. In addition, keep an eye out for companies that claim to have “simple” credit methods but only confuse you with complex formulas that calculate the amount of interest they must give you. Our team at Safe Wealth Plan has simplified the examples provided above to help you understand the concept of each one.
You can also ask our wealth agents at Safe Wealth Plan about an insurance company’s history regarding their renewal rates — also known as the rates for the potential growth that they may offer after the contract for the year passes. Unfortunately, not all insurance companies will share this information with you, but some will publicly post their renewal histories. It’s also wise to remember that every insurance company will have a minimum rate for caps, spreads, and participation rates.
Index Annuity Crediting Method Takeaways
- An interest crediting method is an approach that helps to determine the cash flow of annuitants on your indexed annuity.
- There are three components to index annuity crediting methods, known as participation rates, spreads, and caps.
- There are various index annuity crediting methods, which include annual point to point, monthly sum, and two-year point to point.
Using the right annuity crediting method can have significant results on how much interest you’ll be able to earn from your insurance company, so be sure to take your time and analyze your options. While there are a few factors that go into what determines your final interest amount, understanding how they work will be able to help you make the most out of your options and figure out which will work for your retirement. For more help on your financials, don’t hesitate to visit our website at Safe Wealth Plan to get in touch with one of our annuity crediting experts today.