Fixed Index Annuity Cap Rates Explained
July 17, 2023
Blueprint Income Team
Fixed index annuities can be an effective retirement vehicle for individuals looking to grow their money while also protecting it from market volatility. However, in return for the advantages that fixed index annuities may offer, insurance companies might likewise protect themselves from risk by imposing limits on how much interest you can earn. One such limit is the cap rate, which can have a significant impact on the gains you realize.
What is a fixed index annuity?
A fixed indexed annuity is a type of annuity contract that is tied to an underlying market index, such as the S&P 500, without involving direct investment in the stock market. When the index performs well, a fixed index annuity offers the potential for high returns.
Fixed index annuities also offer downside protection. Because you are not participating directly in the stock market, the losses of the market do not equate to financial losses for you. Even if the market index performs poorly, you will not lose your principal.
What is a fixed index annuity cap rate?
A cap rate is a limit on the amount of interest you can earn on a fixed index annuity. It is expressed as a percentage and determined by the insurance company offering the annuity. The cap rate associated with the annuity is important because it can have a significant impact on the amount you earn. A higher cap rate can result in a higher return, while a lower cap rate can limit your return.
How do fixed index annuity cap rates work?
Cap rates affect how a fixed index annuity grows over its life span. When the underlying market index tied to the annuity performs well, a higher cap rate allows more interest to be credited to your annuity than you would earn with a lower rate. For that reason, higher caps generally mean your annuity has greater growth potential than if it had a lower cap rate.
To better understand how fixed index annuity cap rates work, consider this scenario. You purchase a fixed index annuity tied to the S&P 500 with a cap rate of 7%. During a crediting period, the S&P 500 grows by 15%. Because of the cap rate on your annuity, the full 15% of the index growth does not get credited to your account. Instead, it receives only 7% interest.
In the following crediting period, however, the insurance company could raise or lower the cap rate on your fixed index annuity. If market interest rates are high in the subsequent period, the insurer might decide to place a higher cap, while a period of declining interest rates might lead to a lower cap.
Though cap rates are a limiting factor, you still have the potential to earn better returns compared to other annuity products in years of high index performance. For example, if fixed annuity rates range between 4% and 6%, the growth described in the above scenario (7% due to the cap rate) would earn you a more attractive yield for the given crediting period compared to the fixed annuity rates.
How are fixed index annuity cap rates determined?
Cap rates are determined by the insurance company offering the fixed index annuity and can vary widely from one company to another. Factors that can influence the cap rate include the current market conditions, the insurance company's financial stability, and the type of index the fixed rate annuity is tied to.
Why do insurance companies set cap rates on fixed index annuities?
Fixed index annuities have cap rates because they help an insurance company manage its risk. Insurance companies, like their customers, strive to earn money from their annuity products. They do so by using the premiums customers pay to invest in a variety of assets, such as stocks, bonds, and other financial instruments. At the same time, fixed index annuities offer downside protection that limits index losses and guarantees principal. That downside protection benefits the customer but can decrease the company's ability to profit.
Caps and other pricing levers allow the companies to offset potential losses, protecting their financial stability and helping them to ensure that they can meet their obligations to customers. Without caps, a company could theoretically be exposed to unlimited risk. If the market performed exceptionally well, the company would be liable for paying out significant returns to customers, which could put its financial stability at risk.
Are there fixed index annuities without cap rates?
Yes, there are fixed index annuities without cap rates. Namely, uncapped indexed annuities impose no limit on the amount of interest that can be credited to the annuity account. Therefore, the interest rate on an uncapped indexed annuity can potentially be higher compared to its capped counterpart.
However, the majority of fixed index annuities do feature some form of limiting factor that protects the insurer from risk. Other pricing levers that an insurance company might use are participation rates and spreads. A participation rate limits how much interest you can earn on a particular index gain. For example, if you have a 70% participation rate and the underlying index gains 10%, you would earn 7% overall. A spread is a percentage subtracted from a particular index gain, so a 2% spread on a 10% index gain would equal 8% interest for you.
Even with capped fixed index annuities, the caps aren't always imposed in the same way. Some fixed index annuities may offer a higher cap rate in exchange for a longer surrender period or higher fees, while others may offer a lower cap rate but provide more flexibility and lower fees. It's also worth noting there are fixed index annuities with cap rates that are subject to change over time. This means that while the annuity may have a high cap rate initially, the rate could decrease in the future, potentially impacting the overall return on your contribution.
All of the above factors can affect how much you earn on your fixed index annuity. To determine which arrangement is best for you, it's important to carefully consider the trade-offs of each one.
What are the advantages and disadvantages of uncapped indexed annuities?
If you are considering an uncapped indexed annuity, consider these pros and cons:
Advantages of uncapped indexed annuities
One of the most attractive advantages of an uncapped indexed annuity is its growth potential. Because there is no limit on how much interest the annuity can gain, you may be able to realize substantial gains during crediting periods when the market performs particularly well. That growth potential may also mean that uncapped indexed annuities are a more flexible option compared to capped indexed annuities or other types of annuities, as they could earn at rates that fit into both conservative and moderate retirement planning strategies.
Disadvantages of uncapped indexed annuities
While uncapped indexed annuities may seem like the better choice, it's important to understand that they, too, may come with trade-offs. For example, the fees on an uncapped indexed annuity may be higher than those on a capped indexed annuity, or the annuity may have a more complex index strategy that can make it harder to understand.
Additionally, while uncapped indexed annuities don't have ceilings on interest rates, they may have spreads or participation rates. Given these trade-offs and the possible presence of fees, the term "uncapped" does not equate to unlimited earning potential, as these factors could still limit the actual interest credited to the annuity account.
Ultimately, the presence of a cap rate is an important factor to consider when evaluating a fixed index annuity, but it's not the only one. Other factors to consider are the surrender period, the fees associated with your annuity, and the financial strength and stability of the insurance company offering the product. By carefully evaluating all of these factors, you can make an informed decision about whether a fixed index annuity is the right retirement product for you and which fixed index annuity best suits your time frame, risk tolerance, and financial goals.
Use the resources we provide at Blueprint Income to better understand the annuity products that are available to you. If you have any questions, reach out to one of our annuity consultants at [email protected], or call 888-867-7620 to speak with someone directly.
Blueprint Income Team
We are a team of finance, insurance, and actuarial professionals working to make it easier for everyone to achieve a steady and comfortable retirement. We write about annuities (the good and the bad) and provide strategies to help Americans prepare for retirement.