- Interest rate spreads are a pricing feature of indexed annuities – insurance products that provide investors limited upside potential coupled with the security of a downside guarantee.
- Like interest rate caps and participation rates, rate spreads restrict the growth potential of indexed annuities. These limiting features exist so that indexed annuities can exist.
- Generally, the insurance company issuing an indexed annuity sets a new interest rate spread each contract year. The higher the spread, the lower the potential return.
Indexed Annuities and the Role of Interest Rate Spread
According to the Financial Industry Regulatory Authority, indexed annuities, which are also referred to as fixed index annuities, are riding a notable wave of popularity. This is largely due to the balanced risk-return profile they offer investors.
An indexed annuity’s returns are tied to the performance of a specified market index, such as the Dow Jones Industrial Average (the Dow), the S&P 500 or the Nasdaq Composite, and interest is credited periodically based on changes in the index of focus. Beyond this foundational construct, there are various interest crediting methods and pricing components that influence how much interest an annuity will earn.
A prominent component is the interest rate spread, which can be characterized as a hurdle that must be cleared before interest is credited to an annuity. Read on for additional context on this important contractual feature.
How Does an Interest Rate Spread Work on an Annuity?
Generally, the insurance company issuing an indexed annuity sets a percentage for the interest rate spread each new contract year. This percentage is subtracted from the period-to-period change in the specified index before interest is credited to the annuity. The higher the spread, the lower the potential return.
For example, assume you have an annuity that uses an annual point-to-point crediting method (January 1 measurement date) and an interest rate spread of 4%. If the specified index increases by 10% during the year, only 6% will be credited to your annuity’s value (10% index performance less the 4% rate spread). However, if the interest rate spread were 2%, your annual credit would amount to 8%.
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Why Do Rate Spreads Exist for Indexed Annuities?
To explain why spreads exist for indexed annuities, we need to take a step back and contrast them with the other two types of annuities, fixed and variable annuities.
With a fixed annuity, the annuitant’s rate of return is guaranteed, and the annuity issuer assumes all market risk. Conversely, with a variable annuity, the annuitant’s growth potential is limitless, but he or she generally assumes all market risk.
On the risk-return spectrum, indexed annuities fall between these types of instruments. They can generate higher returns than fixed annuities, but they do not offer as much upside potential as variable annuities.
The returns generated by indexed annuities can exhibit a fair amount of volatility. However, these contracts provide downside protection via a guaranteed minimum rate of return, which is often referred to as a floor.
The minimum guarantee is good for investors, but it exposes annuity issuers to heightened economic risk. They manage this exposure by restricting the growth potential of indexed annuities with interest rate spreads, caps and participation rates.
If these limiting features were not included in indexed annuity contracts, insurers would not be able to profitably sell these instruments – leaving a void between fixed annuities and variable annuities. Ultimately, this would harm consumers looking for limited upside potential coupled with the safety of a downside guarantee.
Interest rate spreads, caps and participation rates exist so that indexed annuities can exist.
Do Rate Spreads Make Indexed Annuities a Poor Investment Choice?
Only the person buying an annuity with a rate spread can attest to whether it is a good investment. All investment decisions are highly personal and should be based on the unique circumstances, investment objectives and risk tolerance level of the investor in question.
That said, if you wish to maximize your money’s growth potential without assuming the downside risk inherent in mutual funds and variable annuities, indexed annuities can be a sensible part of a retirement strategy.
Just remember, annuities are relatively low-risk, low-returning vehicles that are not ideal for long-term investors focused on capital appreciation. They can be highly beneficial to conservative, hands-off investors that value a predictable stream of income, but they do not make sense for everyone.
If you need help assessing whether annuities are appropriate for you, consult with a financial advisor. He or she can help you establish a holistic wealth management plan.
The typical indexed annuitant is an individual that is not comfortable risking loss of principal in exchange for unlimited upside potential. However, he or she desires to earn more than what is available via a fixed annuity.
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Other Frequently Asked Questions About Rate Spreads
Generally, fixed annuities are the safest type of annuity contract you can buy. Indexed annuities are modestly riskier because their returns can exhibit a fair amount of volatility. Variable annuities are the riskiest type of contract because they expose investors to the possibility of losing their initial investment.
Like an interest rate spread, an interest rate cap is a limiting feature of an indexed annuity. Essentially, it puts a ceiling on an annuitant’s crediting rate. For example, if an indexed annuity has a rate cap of 8% and the specified index increases by 12% during a measurement period, the interest credit will be limited to 8%.
A participation rate is another type of limiting feature of an indexed annuity. It specifies the extent to which an annuitant can participate in the performance of the specified index. For example, if an indexed annuity has a participation rate of 80% and the specified index increases by 12% during a measurement period, the interest credit will be limited to 9.6% (0.80 × 12% = 9.6%).