Deferred annuity rates – the rate of interest earned by annuities in their “accumulation phase” – are calculated in a number of different ways, directly related to the type of annuity. For example, fixed annuities earn interest on the principle amount. The interest rate is declared by the insurer, is usually credited annually and increases the amount of principle earning interest (this process is called “compounding”). The return on variable annuities comes both from interest and dividends, and from actual gains from the securities products the annuity principal is invested in.

There are two main reasons investors should familiarize themselves with this material. First, the subject matter itself is fairly complicated, and a misunderstanding made at the point of purchasing an equity index annuity (EIA) could mean the difference of thousands of dollars because an indexing method was chosen that didn't properly reflect the purchaser's wishes. Second, some salespeople themselves might not be thoroughly familiar with how an EIA earns interest, and so may be incapable of providing accurate guidance. Thus, it's absolutely crucial that investors learn and understand the various components of equity index annuity interest calculation and crediting methods.

It's important to keep a fundamental concept in mind when considering EIAs: although the interest earned by an EIA is usually determined by linking its value to an equity market index such as the Standard & Poor's 500 Composite Stock Price Index (S&P 500), the principal amount of the annuity – the original investment – isn't necessarily invested in any particular index fund or security. (This is why no securities license is required to sell EIAs – because there's no risk of loss of principal, it's not considered a true investment.) The insurer invests the money in accordance with its own investment strategy, and the index is used solely as a way of determining the extent to which the annuity owner will participate in the insurer's profits.

There are two main issues to consider in evaluating how a fixed equity annuity gains in value. The first is the insurer-imposed parameters, and include the guaranteed minimum interest rate (usually 0%), any earnings caps, and the participation rate. The second is the indexing method, which is how the interest amount is calculated. Not all EIAs will have an earnings cap, but they all have a minimum guaranteed interest, a participation rate and an indexing method.

Earnings limitations

One of the major selling points of EIAs is that they give you “all the advantages of the market without any of the downside risk.” The way they guarantee that there'll be no loss of principal is to guarantee a minimum interest rate of 0%. This, if the index that the annuity is linked to actually declines in value, the decline won't be applied to the principal value of the EIA (because it's below 0%). The minimum guaranteed rate should be specifically stated to last the lifetime of the EIA.

Many EIAs will carry an earnings cap – usually, significantly higher than any reasonable expectation of what the index's gain will be, and designed to limit the insurer's liability in extreme circumstances. This means that no matter what else happens, the most interest that will be credited to an EIA (usually annually) will be that amount. Earnings caps can be reset annually.

A participation rate is a ratio set by the insurer that sets forth the degree to which an EIA will share, or “participate,” in index gains. For instance, if the participation rate is 75% and the index gains by 10% for the indexing period, the amount credited will be 7.5%. A participation rate is another sort of a cap. Generally speaking, the lower the participation rate, the higher the insurer believes the index will rise. The participation rate, like the cap, can be reset annually.

Indexing methods

There are many different ways an insurer can calculate the interest earned by an EIA, and different methods can be combined. There's no universally-acknowledged “best” system for the investor, and no “worst” system; however, some are superior to others under most circumstances. Investors with a clear set of needs and preferences may favor one system over another.

The first element of indexing involves the actual calculation of change in value. The most simple and straightforward of these is called “point-to-point,” and consists of comparing the value of the index on two different dates (usually the issue date and the maturity date, or individual anniversary dates within the annuity's term), calculating the difference as a percentage, applying that percentage to the principal, and crediting it (usually to the principal).

Another calculation method is called the “high-water mark” method, where the values of the index as several points during the time period used in the calculation (usually either the full life of the annuity or the one year period between anniversary dates) are compared, and the value used in determining the interest amount is the highest of these values.

The “low water mark” is a method similar to the high water mark, except that it assigns the lowest of the values recorded as the opening value for the purposes of calculating gain.

There are variations of these methods, generally associated with the frequency of indexing and method of crediting. Some EIAs, for instance, credit interest once – at the date of maturity, after the annuity has run its course. The vast majority, however, credit interest annually, on the anniversary date, and in most cases, once interest is credited, it becomes part of the principal and thus cannot be lost.

Thus, an EIA which credits interest annually using the high water mark method will take the index value on the same date of each month for the twelve months in the year, and use the highest of those as the closing value – that is, the value against which the initial value is compared to determine the index rate.

In addition to variations of time, many EIAs use an average – that is, they'll take the average of the index's value on the same date every month, and use that value every twelve months to determine the closing index value.

There are advantages and drawbacks associated with each of these methods, generally associated with actual market behavior. For example, if the market steadily advances throughout the year and then crashes the day before an annuity's indexing date, losing all its accumulated gain, the owner of an annuity using an annual point-to-point method won't benefit, but the owners of average monthly value EIAs and of monthly high-water-mark annuities will. (Conversely, if the market does poorly during the year and only recovers near the end of the year, finishing with a gain, the point-to-point EIA owner will earn interest and the other two will likely see no gain for the year.) Generally, though, the longer apart the indexing points, the less accurate a reflection of the market's actual performance it will be. Monthly averaging of the index values is a much more accurate reflection of actual index performance, and owners of EIAs that utilize these methods won't be so vulnerable to violent short-term fluctuations.

“Ratchet and Reset”

An interesting concept used by some insurers is the “ratchet and reset” method. Using this method, the starting value of the index is essentially reset to zero every year. Thus, if the index experiences a major decline during one year (say, 20%), the annuity wouldn't earn anything; if it recovered all of the loss in the next year, the EIA would record a 25% gain. Thus, the EIA would experience an average 12.5% increase over two years while the same amount directly invested in the index fund would be unchanged.

The value of the ratchet and reset approach is linked to the “power of loss.” Simply stated, when an amount is lost from an investment, a greater percentage has to be made up, even if the dollar amount to be made up is the same. That is, if an investment of $100,000 loses $20,000 in value (20%), in order just to break even, the investment has to gain 25% ($20,000 is 25% of $80,000). If an investment loses 50%, it must then gain 100% just to break even.

The ratchet-and-reset approach bypasses the power of loss – if the index linked to an EIA loses value one year, and then gains the next, the EIA will earn in the second year even if the index's gain doesn't fully recover the loss of the first year.

Because a dynamic insurance industry will constantly be exploring new ways to “incentivize” consumers to buy annuities, including EIAs, and developing new methods of calculating and crediting interest is among those strategies, it's critical that consumers periodically review the available literature to keep their knowledge current.