An index is a number that goes up and down as the market it represents changes. When looking to purchase a fixed indexed annuity, your agent will talk to you about how interest is credited. A fixed indexed annuity allows you to benefit from the positive changes in the index (subject to the policy’s caps) while being protected if the index falls. A fixed indexed annuity may credit more interest than a traditional fixed annuity in periods when the index is rising. When the index is falling or remains level, the value of the fixed indexed annuity remains constant. In other words, an indexed annuity allows the policy owner to potentially receive more interest than a traditional fixed annuity, but without being subject to market risk.
Most of the premium dollars paid by indexed annuity policy owners are invested by the issuing company in traditional fixed income securities such as bonds and mortgage loans. These provide the company with secure investments and a steady source of interest income. The secure investments make possible the underlying guarantee that when the index falls or remains level, the value of the policy owner’s account does not fall. It also makes it possible for the company to guarantee a minimum value no matter what the performance of the index might be. This minimum value is in the form of a minimum credited interest rate, on a percentage of the premiums paid.
A small portion of the annual interest earned (this varies from company to company and product to product) is invested in options on the index. This is done to mirror the obligations the company has pursuant to the interest crediting formula and is referred to as hedging. When the index rises, these options are “in the money,” and the company uses the proceeds to credit the interest called for by the interest formula. When the index falls, the options expire without value which mirrors the 0% interest credited that policy year.
It’s important to remember that the values, rates, and policy features can differ from insurer to insurer, so do your research and talk to your agent about which policy is best for you.