how indexed annuities work
indexed annuities offer their owners or annuitants the opportunity to earn higher yields than fixed annuities when the financial markets perform well typically they also provide some protection against market declines the rate on an indexed annuity is calculated based on the year over year gain in the index or its average monthly gain over a 12 month period in years when the stock index declines the insurance company credits the account with a minimum rate of return a typical minimum rate guarantee is about 2 some can be as low as 0 or as high as 3 there are no losses when the market isn t performing well only gains when it is however these gains may be limited via provisions in the contract such as participation rates and rate caps while indexed annuities are linked to the performance of a specific index the annuitant won t necessarily reap the full benefit of any rise in that index one reason is that indexed annuities often set limits on the potential gain at a certain percentage commonly referred to as the participation rate the participation rate can be as high as 100 meaning the account is credited with all of the gain or as low as 25 most indexed annuities offer a participation rate between 80 and 90 at least in the early years of the contract if the stock index gained 15 for example an 80 participation rate translates to a credited yield of 12 80 x 15 many indexed annuities offer a high participation rate for the first year or two after which the rate adjusts downward most indexed annuity contracts also include a yield or rate cap that can further limit the amount that s credited to the accumulation account a 4 rate cap for example limits the credited yield to 4 no matter how much the stock index has gained rate caps typically range from a high of 15 to a low of 2 they are subject to change in the example above the 15 gain reduced by an 80 participation rate to 12 would be further reduced to 4 if the annuity contract specifies a 4 rate cap if you re shopping for an indexed annuity ask about its participation rate and rate caps both can reduce your potential gains from any rise in the markets at specific intervals the insurer will adjust the value of the account to include any gain that occurred in that time frame the principal which the insurer guarantees never declines in value unless the account owner makes a withdrawal insurers use several different methods to adjust the account s value such as a year over year reset or a point to point reset which incorporates two or more years worth of returns 