Fixed Index Annuity Glossary:

Indexing Method

The Indexing methods are the approach used to determine the amount of interest that will be credited to a clients account.  Generally when you purchase a fixed annuity you are making the decision to have the interest credited to your account based on the movement of some index rather than a fixed rate.  There are many common indexing methods, which will be explained later include annual reset (ratcheting), high-water mark and point to point.  

Term

The index term is the period over which the surrender charge is calculated.  There is generally a free withdrawal term available during the annuity term.  Typical terms are between 5-15 years.  At the end of the given term you are generally allowed to withdrawal all of your money without penalty.

Participation Rate

The participation decides how much of the index performance will be credited to your account as interest.  For example, suppose your annuity has a 60% participation rate, and suppose the index for that year went up 20%.  In this example your interest would be 12% (60% x 20% = 12%) credited to your account at the end of that year.   Since this is an annuity contract (you cannot lose money) suppose the performance in the index was  (-15%) the interest credited to your account that period would be 0%.  The company usually determines a participation rate for a specific period (from one year to an entire term).  When the period is over the company generally sets a new participation rate.  Some annuity companies will guarantee a minimum participation rate even if they reset there rate each year.

Cap or Cap Rate

In some cases an annuity company will put a cap on how much of the index performance will be credited to your account as interest.  This is called a cap or cap rate.  For example, suppose your annuity had a cap rate of 8% and the index for the given period was 12%.  In this example your account would be credited with 8% interest.  Essentially you earn the first amount of interest up to the specific cap.  If the change in the index was 4% your account would be credited with 4%, and if the change in the index was (-5%) your account would be credited with 0%.   Cap rates can be set to change every year or they can be set to last the entire length of the contract.

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Floor or Minimum Guarantee

Every equity linked fixed annuity otherwise known as a fixed indexed annuity has a minimum guarantee or a “floor”.  The floor is used because since this is an annuity the owner has to earn something, and since the interest is credited based off the performance of the index, theoretically you could earn 0%  each year if the index performs negatively.  Most annuity contracts have a minimum guarantee that is 1.50% of 100% or 3% of 80% or something of that nature.  1.50% on 100% means that worse case scenario the owner is guaranteed 1.50% each year on their money.  3% on 80% means that worst case scenario the owner is guaranteed to earn 3.00% on 80% of their money.  If the minimum guarantee is less than 100% that means that the surrender charge is already taken out of it and your worst case scenario is the 80% of your premium growing at 3% interest.  

Averaging

Some fixed indexed annuities use the average of a particular index rather than the change from start to finish.  

Compounding Interest

Some annuities pay simple interest during an index term rather than compound interest.  If an index linked annuity pays simple interest it means that the interest that is calculated is based off of the initial investment.  For example if you invest $100,000 and it pays 4% simple each year for three years you will earn $4,000 each of the first 3 years.  If compound interest is used that means that the interest you earn is calculated on the value at that time, interest included.  For example if you were to invest $100,000 at 4% compound interest for three years you would earn $4,000 the first year and then 4% on $104,000, etc.  As you can see compound interest earns more interest over time because your interest is earning interest on top of interest.

Margin / Spread / Administrative Fee

Some annuities, index annuities especially use a Margin / Spread / Administrative Fee.  This spread or margin is subtracted from the percentage of change in the index.  This margin, spread or administrative fee is usually expressed in percentage terms.  For example you may have an equity indexed annuity that has a 3% fee.  In this case, if your equity linked fixed annuity had a 10% change in the corresponding index you would be credited with 7% interest (the 10% change – the 3% fee).  The rate that is credited to your fixed indexed annuity will never be less than 0.  

Vesting

Vesting is a term that is used to determine how much of something is yours to keep.  For example some annuities may offer a 10% bonus the first year of a 10 year annuity.  In this  example it would be common for the annuity to have a vesting schedule where that 10% would vest 1% each year.  If you were to surrender the policy early you would only earn 5% of the bonus, however if you held the annuity until maturity you would earn the entire 10%.  
 

Annual Reset

Fixed indexed annuities determine the interest each year by comparing the index value at the end of a contract year with the start of that term.  At the end of the contract term the index resets.  And your interest in year two is calculated based of the beginning and end of the index.  
 

Point to Point

The index based interest that is credited to your account is determined by figuring out the difference from the beginning of a term and the end.  Typically this is done with a 1 year point to point, but it is not uncommon for index annuities to offer 3 year point to point or even a point to point for the entire term.  Often times there is a cap associated with this indexing option.  For example on an annual point to point it may have a 7% point to point cap.  In that case if the change in the index was 10% you would be credited with 7%.  As with all fixed annuities there is never any risk to your money, so in the event that the index declines in value you would be credited with 0% that year.
 

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