Index Term Period in Fixed Index Annuities: How Does It Work?
Aug 11, 2023
Blueprint Income Team
A fixed index annuity comes with interest that's linked to the performance of a market index such as the S&P 500, which tracks the largest companies in the United States. Linking your annuity's interest to an index like this ties its performance, in part, to the growth of the index. A fixed index annuity provides you with the opportunity for growth while also offering downside protection from market risk.
The index strategy you select determines how often your annuity's cap rate is reset over the entire index term. The length of the index term period can vary and affect your returns. It's important to understand a fixed index annuity's index term periods, index-linked interest strategies, cap rates, and participation rates to determine if it can help you meet your financial objectives.
What are index term periods?
The index term period is the observation period that is used to determine whether any index-linked interest is credited to your annuity. This period also defines how often your cap rate may be reset. The shorter your index term period, the more frequently your annuity's interest is credited and its cap rate reset.
How index term periods work
An index term period is the timeline used to determine if any index-linked interest is credited to your annuity contract for that term.
At the end of the index term, any credited interest is calculated based on the performance of the market index during the index term, subject to factors such as the cap rate and participation rate.
Examples of typical index term periods
The typical index term period for a fixed index annuity can range anywhere from one to 10 years. If your index term period is one year, at the end of the term period, the performance of the index will determine the interest that is credited to your annuity, up to any cap rate that may exist.
If your index term period was longer at three years, the same procedure would apply. The only difference is that the performance of the market index that your annuity is linked to would be evaluated over three years instead of one.
What to consider when choosing an index term period
Your index term period can vary depending on the insurance company and your specific annuity contract. Some insurance companies offer a few index term periods for you to choose from, while others have one index term period for your entire annuity.
Index term period length
There are pros and cons to having both shorter and longer index term periods. It's important to understand them both to choose the right term period for your fixed index annuity.
Shorter index term periods credit any interest earned and reset your annuity's cap rate more frequently. They can help you lock in gains over shorter time periods if the market index has positive performance. If the performance of the index is negative, no interest would be credited. However, your principal is protected.
Longer index term periods credit any interest earned and reset your annuity's cap rate less often, They can allow your annuity to benefit from gains in the market realized by the end of the full index period, even if the market experienced some negative performance during that time.
This is why it's important to choose a term period that aligns with your financial goals. If your priority is to seek long-term gains, having a longer index term period may be the better option for you. Shorter index term periods can offer higher gains in a rising market, but they come with the added risk that you aren't credited with any interest if the market falls during your index term period.
You generally choose the index term period for your fixed index annuity at the beginning of your annuity contract. While some insurance companies may allow you to change the term period during your investment term, others may require you to have the same index term period for the entire annuity contract.
How your index term period affects your credited interest
The following factors influence how the index term period you choose for your annuity ultimately impacts the amount of index-linked interest that may be credited at the end of the index term:
Protection against market fluctuations
An index term period is designed to help protect your annuity against market fluctuations that can occur during the short term. A shorter index term period credits your interest more frequently if the linked market index has positive performance, so it can lock in gains if the linked market index does well during that period. However, this could also result in no or less index-linked interest being credited if the market index has poor or negative performance during the index term.
A longer index term period provides more protection against short-term market fluctuations, as any index-linked interest that may be credited is calculated over a longer period of time. In this way, market fluctuations over the short term won't have as much of an impact on your annuity's performance.
Cap rate and participation rate
It's important to remember that your gains may still be limited by the participation rate or the cap rate of the annuity. The cap rate is the maximum amount of index-linked interest that may be credited to your contract. If the cap rate is 7%, the participation rate is 100%, and the market index rises by 10%, your credited interest will be 7%, as the cap rate limits the credited interest.
The participation rate defines the percentage of the index performance on which your annuity's credited interest is based. If your participation rate is 70%, and the market index increases by 10%, your credited interest will be 7% — even if your cap rate is higher, as the participation rate limits the credited interest. To determine how much interest will be credited based on the participation rate, you can use this formula:
Total return x participation rate = interest credited
Index crediting methods
There are a few index crediting methods that can be used to determine the potential for growth of your fixed index annuity, each with different ways of measuring market index performance. While some insurance companies have fixed indexing methods, others may offer you a choice for your individual annuity contract.
Certain indexing methods can be more beneficial for different index term periods. If you have a short index term period, indexing methods such as the high-water mark method can help you achieve the greatest return even if the market index fluctuates during the term. However, the point-to-point indexing method can be better for longer index term periods to realize the long-term gains of the market index.
Point-to-point indexing method
The point-to-point indexing method is calculated by determining the percentage change in the market index to which your fixed index annuity is linked. The value of the index at the start of your index term period is compared to the value of the index at the end of the index term period.
High-water mark method
The high-water mark method takes the highest point of the market index during your index term period. This method can result in higher index-linked interest credited to your annuity if the market index reaches a high during your index term before dropping back down at the end of the index term period.
Renewal cap rates
Renewal cap rates are set at the end of the current index term period, and determine the cap rate and potentially the participation rate for the subsequent index term period. If you have a one-year term period, you will be subject to a renewal cap rate every year. This can have a positive impact on your annuity's performance if the linked market index is performing well.
If you have a longer index term period, your renewal cap rates occur less often, which can offer you more stability and predictability of returns over time.
Which index term period is best?
The index term period in your fixed index annuity is designed to protect your investment by determining how often your interest is credited and cap rate is reset. Index term periods can vary depending on your insurer and the individual annuity contract.
Shorter index term periods credit any interest earned and reset your annuity's cap rate more frequently. Longer index term periods reset your interest less frequently and can help lock long-term gains in the market despite short-term fluctuations.
Recap of key points of term periods
- An index term period determines how often your fixed index annuity's interest is credited and cap rate is reset.
- Index term periods can vary depending on the insurance company and your particular annuity contract.
- Shorter index term periods mean your credited interest is determined and your cap rate is reset more frequently than longer index term periods.
- Longer index term periods may be better for potential long-term gains.
If you want to learn more about fixed index annuities, our team at Blueprint Income is here to help. Visit our website for more information, or get started today with our intuitive guide.
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.