The growth of indexed annuities aligns with the performance of a particular stock index, such as the S&P 500. Interest rate caps denote the maximum amount of interest an annuity can earn — regardless of the change in the index. Insurance companies have the right to adjust these caps every year.
How Do Interest Rate Caps Work?
Insurance companies set interest rate caps on indexed annuities as part of their pricing strategy. As opposed to fixed annuities, which establish a guaranteed interest rate for a set period of time, or variable annuities, which allow contract holders to invest directly in the market, FIAs employ specific pricing strategies and crediting methods to calculate the interest that will be credited to the contract each term.
Annuity providers determine a “cap rate,” an interest rate that limits the growth of an indexed annuity. This cap ensures that the annuity provider can meet their obligations and still make a profit on the product. Indexed annuities have higher growth potential than fixed annuities, which means annuity providers must protect their portfolios in the event that the index sees a drastic upswing.
In order to balance their obligations to annuity owners with their ability to offer a wide range of annuities, insurance companies apply a maximum interest rate, or cap, to indexed annuities. Rate caps and other pricing levers are a win-win, as they allow consumers to enjoy higher gains without exposing them to market volatility in the way that variable annuities and equity investments do.
For example, if you own an indexed annuity with a 7% interest rate cap, but the index earns 12% during the contract term, the annuity will be credited only the cap of 7%, so growth is limited. Depending on the terms of the contract, the FIA could produce better results than a fixed annuity with a guaranteed rate of 5.95%.
Why Do Fixed Index Annuities Have Caps?
When it comes to annuities, interest rate caps limit growth, and interest rate floors limit losses. The caps offset the insurer’s financial risk in the case of major gains in the index.
For example, if an insurance company issues an indexed annuity with a 0.00% floor and the index falls by 3%, the annuity owner’s premium is protected by the floor — that is, the minimum rate of 0.00%.
The insurance company, in this case, has assumed the market risk. It has absorbed the loss. It’s this risk transfer, which is the reason annuities and other insurance products exist, that make the caps necessary. As with any for-profit business, insurance companies seek to make money, not lose it. Without limiting earnings on indexed annuities, the insurance company couldn’t afford keep these products on the market. They simply wouldn’t be consistently profitable.
Insurance companies use other pricing levers — including rate spreads and participation rates — to ensure they can make money on fixed index annuities, thus maintaining these types of annuities among their product offerings.
Rate spreads refer to the percentage subtracted from index gains. For instance, if the annuity has a 4% rate spread and the index earned 9%, the annuity will earn the difference: 5%.
Participation rates are multiplied by the index change to arrive at the amount of interest that will be credited to the contract for the term. A participation rate of 75% multiplied by an index gain of 10% would result in a credit of 7.5%.
At least one of these pricing levers is usually applied when crediting interest to an FIA.
The annuity providers specify the pricing levers and interest crediting methods in the contracts, so consumers can anticipate the gains.
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Do All FIAs Have Caps?
Not all fixed index annuities have caps. Insurance carriers can limit growth through alternative methods or pricing levers.
Annuities are highly customizable insurance products. From riders and beneficiary designations to term lengths and payout options, annuities of the same type can be vastly different in the income they generate and how they generate it.
Understanding ‘Uncapped’ Indexed Annuities
The most important thing to know about uncapped indexed annuities is that they are not limitless. Despite their appealing moniker, uncapped annuities are priced to fit the carrier’s investment portfolio. All FIA gains are limited, whether by caps, required allocation strategies, or another pricing lever.
If anyone tries to sell you an uncapped indexed annuity on the pretense that it will provide you unlimited upside potential, walk away. This person is either unsure about how the products work or is deliberately misleading you.
Benefits of Uncapped Indexed Annuities
The primary benefit of an uncapped FIA is its ability to provide principal protection in conjunction with the opportunity to realize significant gains when the market goes up. Conservative to moderate investors may be suitable candidates for uncapped FIAs, as this benefit is likely to align with their goals. These clients may be approaching retirement and seeking a safety net with their portfolios.
Uncapped indexed annuity providers may lower the participation rate to offset the missing cap, but the buyer’s growth potential remains high — if the stock index delivers high returns over time.
Indexed annuities, with or without a cap, provide premium protection. The added benefit of an uncapped annuity may make these products a better choice than other types of annuities for certain people in certain circumstances. But there’s no guarantee that an uncapped indexed annuity will outperform bonds or mutual funds.
Disadvantages of Uncapped Indexed Annuities
Although the interest rates are uncapped, they are not unlimited. These annuities will not necessarily produce the results a more aggressive investor may be looking for. Interest rate caps are just another method by which insurance carriers price their products.
Uncapped annuities may offer any combination of features priced differently from one provider to the next. This can result in a confusing contract that applies a variety of formulas and interest crediting methods. In other words, you may not be able to decipher the contract, let alone understand how the lack of an interest rate cap benefits you.
These products are typically not ideal for younger, more aggressive investors. Fixed index annuities are long-term vehicles with lengthy accumulation phases, and buyers will most likely owe surrender fees if they want their payout prematurely.
Interest rate caps — or the lack thereof — can complicate your calculations for the annuity itself and your financial plan, so it is important to speak to a financial advisor who can provide context and guidance.
