Fixed Indexed Annuities: What is a Participation Rate, Cap, Spread and Reset Period

Troy Sharpe:  In 2019, retirees and pre-retirees invested over $73.5 billion with a B into fixed indexed annuities.  If you’re over the age of 50, at some point you’re going to be approached with this tool to be added to your portfolio by someone most likely. I want to make sure you’re armed with the knowledge and you  understand the basics as well as some of the more sophisticated concepts, so you can make a good decision of whether this tool can fit into your retirement strategy

Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, CERTIFIED FINANCIAL PLANNER™ Professional (CFP®), and host of The Retirement  Income Show. We’re going to talk about what is a participation rate? What is a cap? What is a spread? And what is a reset period? Which is the very basic elements of a fixed  indexed annuity contract. Which, again, these fixed indexed annuity contracts are issued from life insurance carriers as a promise made to you. They come with 100%  principal protection but the waves they earn interest vary across the board.

These elements exist in all of the fixed indexed annuity contracts out there so understanding these  basic concepts will really help prepare you to understanding some of the more sophisticated concepts we’ll get into later in this video series. A participation  rate quite simply is the amount we participate in the growth of the underlying index that we track. With fixed indexed annuities,  we do not have our money invested directly in the stock market.

We participate in the stock market gains if the index goes up  but the money is never placed directly into the stock market. That’s why you have 100% principal protection guaranteed. There are different, if you consider them  formulas or calculations, of how the life insurance company will determine how much interest you earn for the year. We need to have this basic understanding. Here, I’ve given a few  examples. The participation rate is how much we participate in the underlying index. I’m going to assume for the purpose of this video that all these scenarios we’re tracking the S&P 500.

It’s the most widely known index in America and it is comprised of the 500 largest companies in America. If we have a 100%  participation rate but an annual cap of 6% and a 0% spread, if the market does 10%, we make  100% of that gain up to 6%. If the market does 10 you make 6. If the market does -10, you don’t lose any money. Your  money is protected. If you have a 50% participation rate in the index, you may have an uncapped strategy available  to you.

This simply means there is no cap but they’re going to lower the participation rate. In this index, if the market does 10% you get half of that  gain but there’s no cap so you make 5, 50% of 10 is 5. If the index does 20, you could make 10%. Again, here there’s a 0%  spread. Another way you might see this is with a bit higher participation rate, a bit higher cap but then they’ll add  this spread. A spread is a reduction of the earnings off the top. It’s not an annual fee. Most fixed indexed annuities do not come with annual fees unless you  add a rider by choice. In this particular example, if the S&P 500 did 10%, you would make 80% of that, so 8,  subject to a 10% cap, so you didn’t reach the cap but then they would subtract 2 off that 8 and you’d be left with 6% interest for the year.

What if the market did 30%?  Well, 80% of 30 is 24% but you’re subject to a 10% cap. You would make 10 they would subtract 2  your 100% safe investment. Therefore it would be left with earning 8% interest for the year. Now, this is just a very, very simple and general example  but it helps you start to understand what the terms participation rate means. What a cap is. There are a lot of strategies out there that are uncapped and it’s not that one is necessarily better  than the other.

Every contract is different and you really need to understand the basics in order to help decipher what some of the terminology means. Not all contracts  have spreads but if you do see a spread, remember it’s not an annual fee it’s simply a reduction off the earnings. One of the things about a fixed  indexed annuity is once they calculate your interest gains no matter which formula your specific contract has, there is what we call a reset period.

A reset period is normally over a 12 month period but it could be over a two-year period or a three-year period, and I’ve seen them sometimes even over a five-year period.  What a reset period means is that is the timeframe that which we are tracking that particular index. Once that reset period, if it’s 12 months or one  year, whatever gains we made in that one year, they’re locked in. The gains that you made or added to your principle, they can never be lost and future gains will compound  on top of those gains.

This is assuming what we call an annual reset. If the S&P 500 is going up  and let’s say the market does 12% here and we make 6, well, our 100,000 turns into 106 but that is our new principal that will never be worth less than  106. Market goes up again we go from 106 let’s say to 115. Those gains lock in. This trend continues until the market goes  down. When the market goes down, you don’t earn any interest. You earn a zero that year but you don’t give back any prior year’s interest gains because they’re locked in.

I prefer to see these types of strategies with an annual reset but you will have options available to you where we will get higher participation rates,  higher caps, possibly uncapped strategies, and lower spreads if you’re willing to track the market instead of a one-year period, if you’re willing to track it over a two year  period or sometimes even a three-year period.

Many different ways to calculate how much interest you earn in these financial tools, this is a primer to help you understand the basics.  As we get into more sophisticated concepts here, we’re going to stack on top of what you’ve learned today. In the next video in this series I’m going to show you one of the more innovative concepts that  has recently been developed that can allow you to have up to 110%, 115% sometimes 120%, 130% participation with no cap. This is what we  call a volatility-controlled index and I’m going to show you how that strategy works in the next video.

Again, this is nothing more than a financial tool, they’re designed to provide peace of mind, safe growth  for your money but they do have additional benefits we’ll get into. If you liked this video make sure to share it with a friend or a family member also hit that thumbs up button. If you push the subscribe button you’ll  be updated whenever we upload new content to keep you more connected to your money.

 

 

 

Summary
Fixed Indexed Annuities: What is a Participation Rate, Cap, Spread and Reset Period
Title
Fixed Indexed Annuities: What is a Participation Rate, Cap, Spread and Reset Period
Description

In this episode with Troy Sharpe, CFP®, Troy discusses the key terms that you need to know before using a Fixed Annuity in your retirement plan. Troy talks about Participation Rates, Cap's, Spreads and What a Reset Period is.