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Finding Top Indexed Annuities

Just when we thought we were beginning to understand how annuities worked, along came indexed annuities to, once again, make us feel a little inadequate. The good news is that they provide investors with a very good alternative to lower yielding fixed annuities and the more risk-oriented variable annuities. The problem is that they are much more difficult to understand because they utilize several factors to determine the actual yield that is credited. If you’re trying to determine how to find the best indexed annuities, this guide will help tell you what you should look for when comparing them.

Indexed Annuity Basics

Essentially, indexed annuities are a variation of fixed annuities, but instead of a single fixed interest rate credit, the actual credited yield is based on either the percentage gain in one of the stock indexes, or a minimum fixed interest rate, whichever is greater. From here it gets a little convoluted so, pay attention.

Most indexed annuities are linked to a specific stock index, such as the S&P500. From the moment your funds are deposited, the movement of the stock index is tracked, so that, at the end of one year, if the index shows a percentage gain (i.e. up 10%), your account is credited a return based on a portion of that percentage gain. The credited portion is determined by applying to key factors: a participation rate and a rate cap. After they are applied, a net rate of return is credited to your account which is always lower than the actual percentage gain of the index. If the index shows a percentage decline (i.e. down 10%), a minimum rate guarantee kicks in, which guarantees that your account will not lose value.

That’s the thirty thousand foot overview, but the devil is in the details. Understanding these factors and how they are applied is key to determining which indexed annuities are the best for your particular situation.

Indexed Annuity Components

Index Link

The first important consideration is deciding which market index you want your account values to follow. The S&P 500 is a broad stock market index comprised of larger capitalized companies. It may be more stable than another index that is comprised of smaller companies that have more growth potential, but also more volatility. Some indexed annuities have a blend of indexes for even greater diversification. The key is to choose the index, or mix of indexes that most closely matches your investment preferences.

Participation Rate

The participation rate is the percentage of the gain that will be credited to your account. The rate can range from as low as 25% to as high as 90%. So, if the percentage gain in the stock index is 20%, and the participation rate is 70%, your credited rate, before the rate cap is 14%. The life insurance company keeps the other portion to offset its costs.

It would seem that the best strategy would be to consider indexed annuities with the highest participation rate. While that may be a good place to start, be aware that some products offer a very high participation rate as an enticement, but then drop the rate after a year. It may be better to consider products that offer a lower initial rate, but with a long term rate guarantee.

Rate Cap

A rate cap, which is essentially a maximum allowable rate that can be credited, is applied after the participation rate. These rates can range from 4% to as high as 15% depending on several factors, such as the participation rate and the length of the surrender period. Some contracts don’t have a cap rate at all, but their participation rates are very low. So, if after the participation rate is applied, the net return is 14%, a 10% cap rate would mean that the account is credited with 10%. The life insurance company retains the remainder of the gain as a way to create the reserves necessary to protect your values in a market decline.

Obviously, the higher the cap rate, the better, but it may not be if the participation rate is too low. It may be better to choose a contract with a higher guaranteed participation rate and a lower cap rate. Either way, it is important to know whether or not they are guaranteed or subject to change. Typically, contracts that have longer surrender periods will offer higher cap rates.

Floor Rate

Up to this point, the contract rates have been chipping away at your return, but they are there, in part, so that you can have a floor rate which is your downside protection. The floor rate is the minimum rate that can be credited to your account no matter how much the stock index declines. These rates can range from 0% to 3%. While 0% may not seem so great, it is still the assurance that your principle will not lose value. Always go with the higher floor rate, but be sure to check to see how long it is guaranteed.

Credit Period/Method

Your account value is credited once per year using one of four methods:

Annual rest: The actual year-over-year percentage gain, after the participation rate and rate cap are applied, is credited to your account which is then reset so that the increased value becomes the new basis in the contract. This ensures that your account value will never drop.


Similar to the annual reset except that the reset period consists of multiple years, typically five years.

High watermark

This method looks back on the year to apply the highest gain achieved during the year.

Monthly averaging

The position of the index is tracked each month of the year, added together, and then divided by 12 to determine the yield.

Of the four, the annual reset is the more appealing option. You will tend to find the point-to-point method used more often.

Surrender Period

Although most indexed annuities are sold without a sales load or commission, the life insurance company recovers some of its selling costs through surrender fees. A surrender fee applies when a withdrawal that exceeds 10% of the account value is made during any year in the surrender period. The fees can be as high as 15% and the surrender period can last as long as 15 years. Typically, the surrender fee is reduced by a percentage point each year and is scheduled to drop to zero by the end of the surrender period.
It is not uncommon to see indexed annuities with higher participation rates, or rate caps, or floor rates also have longer surrender periods and higher fees. However, if you aren’t concerned with the longer commitment of your funds, you will tend to benefit by choosing contracts with longer surrender periods.

Compare, Compare, Compare

With these key components as your criteria, you can more easily conduct a side-by-side comparison of indexed annuity contracts. One important factor to keep in mind is the strength and stability of the life insurance company that is backing the contract guarantees and your principle. You are probably much better off looking at the products issued by the most highly rated companies.

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