Once you understand the concept of annuities and how they work you start to realize they really are one of, if not the, safest financial products on the planet. Where else can you put your money that will give you market-like gains, with no fees (with the exception if you need a rider), and protect your principal from loss?
However, one of the areas that I hear confuses people the most is the crediting methods. Fixed Indexed Annuities provide gains to their owners in one of 3 ways, outside of a fixed interest rate.
They are:
- Cap Rates
- Participation Rates (Par Rates for short)
- Spreads
I believe most people understand cap rates because that is one of the first objections that I hear from clients. Normally, someone told them (most likely their advisor) that they will be limited on gains because “annuities have caps.” Even if that were the case for all annuities, and it’s not, that’s okay. The purpose of an annuity is to protect. And if the trade-off for that protection is a cap, then it is what it is. But that’s not the whole story. If you have ever read my “Atlas Annuity Rate Report”, you know that double-digit returns are possible.
Let’s jump right into the different crediting methods and how they work with a very easy example.
Cap Rates:
A Cap Rate is just what it sounds like, a “cap”. A “ceiling”. A “maximum amount” that can be earned. Here’s an example:
You have a Cap Rate of 5%.
The chosen index increases 10%.
You are credited with 5% growth.
It’s that simple. You will be credited everything up to and including the Cap Rate amount, and no more.
I’m not a big fan of Cap Rates for that very reason. They can limit your returns. I much rather see a client in one of the other 2 crediting strategies: Participation Rates & Spreads.
Participation Rates:
Also known as a “Par Rate”, for short. These are very easy to understand. Here’s an example:
You have a Participations Rate of 50%.
The chosen index increases 10%.
You are credited with 5% growth (or 50% of the growth).
Very easy to understand. Participation rates are all over the place. Ranging from 20% to 200% on certain indexes. If the Par Rate is over 100%, that means your annuity would be credited with more than the index growth. I’ll explain why below.
Spreads:
Spreads are the crediting method that most people become confused with, but again it’s very simple to understand. Here’s an example:
You have a Spread of 5%.
The chosen index increases 10%.
You are credited with 5% growth (everything above the spread amount).
Again, very easy to understand. Sometimes you’ll see a combination of these, but now you’ll know how to do the math.
Let’s say you have chosen an index with a 100% Par Rate, and a 5% Spread. The index increases 10%. What is your growth?
5%!
That’s because you will get 100% of the growth of everything above 5%, which in this case is, 5%.
If this same index goes up 25% the following year, what would be your growth?
20%!
That’s because you will get 100% of the growth of everything above 5%! That reason right there is why I’m not a big fan of Cap Rates. With Participations Rates and Spreads, your growth is unlimited.
And of course, all your gains are locked in forever. So, even if that same index crashes the following year, you will be credited 0% with no losses to account for.
Now that you understand the crediting methods, let’s talk about some general principles. A good “rule-of-thumb” is, the more volatile an index, the lower the Cap and the Participation Rates will be, and the higher the Spreads will be. All of that comes down to the options budget the annuity company uses to participate in the different indexes. I’ll write about that another time.
The more stable an index is, the higher the Caps and the Participation Rates will be, and the lower the Spreads will be.
Another thing that will affect the crediting rates is the length of the “crediting term.” There are several different crediting methods, but 2 of the most common are:
- 1 Year Point-to-Point
- 2 Year Point-to-Point
What that means is that a “1 Year Point-to-Point” will take a snapshot of your chosen index at the time your annuity is issued, and another snapshot 1 year later. If there is positive growth in the index between those two snapshots, you will be credited growth based on your Cap, Par Rate, or Spread. Just like in the examples I showed above.
And it’s the same scenario for the “2 Year Point-to-Point”.
Another “rule-of-thumb”:
The longer the crediting period, the higher the Cap Rate and Participation Rate will be, and the lower the Spreads will be.
There are crediting terms as long as 5 years. I would suggest to most people to never go longer than a 2 Year Point-to-Point. Three, four, or five years is a very long time to wait for some growth on your money. And if your crediting term ends in the negative, you have to wait another 3, 4, or 5 years for the opportunity for growth. That’s irresponsible for me to recommend, and way too long for you to wait.
Hopefully, the last part of this article did not get too confusing. The most important thing to walk away with from reading this newsletter is to have a basic understanding of Caps, Par Rates, and Spreads. Everything else we can talk about in detail when you take the time to click the “Schedule A Call” button in the top right corner of this page. We can have a short phone call to talk about what you want to see happen with your money. And also, take the time to watch my video series, “How to Get 20% More Spendable Income in Retirement” to learn how I use the best annuities and the best strategies to get you the most return on your money, while also protecting it from market losses!
All the best,
Marty