The Guaranteed Part        Top                  
All fixed annuities offer a minimum guaranteed return. For fixed index annuities this minimum guarantee promises an accumulated value at least equal to the original principal by the end of the surrender period. To provide this minimum guaranteed return the insurance company invests in bonds or other instruments.

Index annuities set their minimum guarantee at 1%-3% interest, which is similar to the minimum rate offered by many fixed rate annuities. However, most index annuities base this minimum interest rate on less than 100% of the premium received.

If the 3% guaranteed return is calculated on less than the full dollar of premium then the minimum effective annual return is less than 3%. Why would one accept a minimum return calculated on less than 100% of the premium? Because it may provide the potential for a higher overall return.

If we had credited 3% on 100% of the premium the minimum return would have been $1.30 at the end of 9 years. But, if we could find those bonds earning and reinvesting at 7% the insurance company would need to invest 71 Cents out of each dollar to provide the $1.30.

After the premium is placed in the insurer’s general account we’ll say that 9 cents out of every dollar goes to cover the agent expenses, insurance company expenses and insurance company profits. That means we have 91 cents remaining from our premium (in actuality these expenses are prorated and taken over an extended number of years).

The next step is ensuring that the minimum guaranteed return is met. The amount needed to protect the minimum guaranteed return depends upon what percentage of premium the minimum return is calculated on and the return earned on the insurance company’s portfolio. If we go back to our example, a minimum return based on 90% of the premium would require 63 Cents and a minimum return based on 100% of the premium would require 71 Cents of the dollar.

We have 91 cents remaining after expenses. A 90% guarantee would cost 63 cents leaving 28 cents remaining. A guarantee based on 100% of the premium would cost 71 Cents which leaves 20 cents remaining. A higher guarantee costs more which means fewer pennies are left to buy the options which provide the potential for excess interest.

The Option Part        Top                              
Most insurance companies buy options on the underlying index. An option gives you the right - not the obligation, to buy or sell something within a period of time. When you compare buying direct equity investments outright with investing in a combination of bonds and options, buying options in this manner is a more conservative financial strategy.

To use a specific stock example...Say that you could buy a share of XYZ stock for $50. If you bought the stock and it rose to $60 you could sell it and net a $10 profit.

Instead of buying the actual stock we could buy an option that gives us the right to buy the stock for $50 at anytime over the next year. The cost of the option is $2. If the stock price rose to $60 we would use or exercise our option and buy the stock at $50, sell the stock at $60, and make $10 - less the $2 cost of the option. Buying an option gives us the right to participate in the growth of the value of the stock, but the real story behind options is what happens if the stock goes down.

What would happen if we bought the stock at $50 a share, but instead of going up it went down. If the price of XYZ stock fell to $40 or $30 or $10 a share we’d lose $10 or $20 or $40 a share. However, options give us rights, not obligations. If we had bought an option for $2 instead of buying the stock itself, and the price of the stock fell to $40, $30, $10 or even zero, the most we can lose is $2 - the price of our option.

The previous example talked about an option on a specific stock. The options purchased by the insurance company usually are for the entire index.

Suppose that the index annuity based the crediting of excess interest on movements of the fictitious Federal Stock Index. Suppose that the index was at a level of 100 and you could purchase an option that would give you the right to buy the index at a level of 100 at anytime prior to the end of the seventh year.

If at the end of the seventh year the Federal Stock Index had a value greater than 100 you’d use the option. If the index was at 170 you’d exercise the option to buy the index at 100, sell the index at 170 and make a gain of 70%. [(170-100)/100 = .70].

If the index was at a level of 100 or less you wouldn’t use the option. But, even if the index was down 20%, 40% or 100% the most you would lose is the money you paid for the option.

This is how index annuities participate in the index. Although option prices are more volatile than direct equity prices and if the index closed lower than the 100 the option would be worthless while the index itself would still have value, the combination of owning both the option and the bonds means the index annuity owner still receives a minimum return even if the index goes down and the option expires worthless.

Summary        Top  
A dollar of index premium is allocated to cover expenses and provide a minimum guaranteed return; if there are any pennies remaining options are purchased to provide the potential for excess interest.  The minimum guarantee assures the owner of an accumulated value at the end of the surrender period at least equal to the original premium.  The minimum guarantee is typically not credited each contract year and only comes into play if the index-linked interest credited is less than the minimum guarantee at the end of the surrender period.

Buying options gives you rights, not obligations.  If the index level at the end of period is higher than it is at the beginning the option is used, or exercised, and a gain is realized.  The participation rate offered by the insurer is based on the price of the options and the money available to buy the options.  This means a participation rate could be 100%, greater than 100%, or lower than 100% depending upon how many options may be purchased.

All information is for illustrative and educational purposes only,  does not provide investment or tax advice, and is not an inducement to buy or sell anything.  Information is from sources believed accurate but is not warranted. Advantage Compendium neither markets nor endorses any financial product.