One of the biggest advantages fixed indexed annuities offer is their loss protection. Regardless of what happens in the stock market (or the index your FIA is tied to), your investment is guaranteed to never go down. At worst, you’ll see zero percent growth, which is better than depreciation.

Having said that, these limitations go both ways. In addition to having that guaranteed protection against market loss, fixed indexed annuities also have rate caps, which limit how much interest you can earn. Rate caps are set by the FIA’s issuing insurance company, who are allowed to adjust them at the renewal of each term. Despite the limits they impose on interest earnings, rate caps are essential in ensuring FIAs can remain on the market. They help insurance companies meet the obligations their FIA product promises, while still being able to turn a profit.

Your typical rate cap for a fixed indexed annuity usually falls between 3-7% on an annual basis. For example, let’s say your FIA has a four percent rate cap, and the stock market index it’s tied to grows by 10%. The annuity will earn no more than four percent interest, despite the index growing by 10%.

To break it down further…

If the value of your fixed indexed annuity is $100K…

Your FIA’s rate cap is four percent…

And the index it’s tied to grows by 10%…

Your FIA will earn $4K in interest, bringing its total value to $104K.

After the earned interest is credited, the FIA’s adjusted total ($104K) becomes the new basis for accumulation value going forward.

Conversely, if the index that your FIA (valued at $100K) grows by 3.5%…

And it has a four percent rate cap…

Your investment will earn the full 3.5% interest, since it’s beneath the four percent threshold – putting the FIA’s new value at $103.5K.

As previously mentioned, insurance companies have the right to increase or decrease rate caps at the renewal of each term (which can be anywhere from a monthly to yearly basis). That means the maximum amount of earnable interest may increase or decrease.

Let’s say your FIA’s insurance company’s current rate cap is at four percent…

And they raise it to 5.5% upon renewal…

If you have a FIA valued at $100K, the maximum interest you can earn in your next term rises from $4K to $5.5K.

On the flip side, if the insurance company lowers its rate cap from four percent to 2.5%…

Your maximum earnable interest off a FIA valued at $100K declines from $4K to $2.5K.

So in essence, although your FIA investment will never go down, the amount of earnable interest can change.

Insurance companies determine their rate caps using participation rates. This metric calculates the percentage of a stock market index’s growth that gets credited to the FIA. This is an important measurement for insurance companies because they must earn enough on their investments to allocate interest payments, pay administrative costs, and make a profit. An insurance company won’t sell the product if it isn’t profitable.

For example, if a fixed indexed annuity has an 80% participation rate, and the index it’s tied to generates a 10% return, the FIA will be credited 80% of the index’s total growth. In this case, the fixed indexed annuity can earn up to eight percent interest.

The actual calculation is pretty straightforward. Sticking with the example above, all you have to do is multiply 10 (percentage of stock market index’s growth) by .8 (participation rate percentage) to get the FIA’s maximum earnable interest rate.

Sources:

https://www.annuityexpertadvice.com/cap-rate/
https://www.annuity.org/annuities/types/indexed/caps/
https://www.ohioinsureplan.com/indexed-annuity-accounts-the-role-of-spreads-caps-and-participation-rates/
https://due.com/annuity/what-is-a-fixed-index-annuity/