How An Annuity Indexing Strategy Helps with Volatility

Retirement can be as exciting as traveling the world or as relaxing as spending a day on the beach. Whatever your vision is, it takes careful planning to get there. An indexing strategy may help protect you from the downfalls of a volatile market, helping you overcome other challenges such as rising health care expenses and longer life expectancies.

As you save for retirement, growth that is linked to the market is key to helping assets keep up with inflation for the long haul. An indexing strategy attempts to mimic the performance of a market index, such as the S&P 500, while minimizing exposure to volatility by providing protection from downfalls in the market.

An indexing strategy is the foundation for the calculation and crediting of interest on an indexed annuity. An indexed annuity provides the potential for cash accumulation with an interest rate that’s linked, in part, to the performance of one or more equity indexes, WITHOUT exposure to loss from potential downfalls in the market. Your annuity can grow based on how an index performs, but you’re not actually buying any stocks or shares of an index. This means the money in your annuity is not at risk due to market losses. Your annuity cannot lose money due to volatility and the interest credited will never be less than zero. For example, if an insurance company issues an indexed annuity with a 0.00% floor and the index falls by 3%, the annuity owner’s premium is protected by the floor — that is, the minimum rate of 0.00%. In exchange for this floor that protects from loss, there is usually a cap on the growth of the index.

What is a cap rate?

As you investigate an indexing strategy, you might be asking yourself, what is a cap rate? Interest rate caps designate the ceiling, or maximum gains, for indexed annuities. The growth of indexed annuities aligns with the performance of a particular index. Interest rate caps denote the maximum amount of interest an annuity can earn — regardless of the change in the index.

As opposed to fixed annuities, which establish a guaranteed interest rate for a set period, indexed annuities have higher growth potential than fixed annuities. For example, if you own an indexed annuity with a 10% interest rate cap, but the index earns 12% during the contract term, the annuity will be credited only the cap of 10%, so growth is limited.

As you start to understand what a cap rate is, you may also be wondering why indexed annuities have them. The insurance company, in this case, has assumed the market risk. It has absorbed the loss. Without limiting earnings on indexed annuities, the insurance company couldn’t afford to keep these products on the market.

Think a cap will hurt your earnings?

Look at a hypothetical example based on the actual performance of the S&P 500 Index from January 2001 – December 2022¹ to see the effects of a cap and floor. There are several ups and downs in the S&P during this time, which provides a realistic example of how an indexing strategy works during a volatile period, with many ups and downs in the market.

Notice the difference between the two values over the years. The capped option is usually higher, even though its average annual return was about 1.6% less than the uncapped option. That’s because, during periods of decreasing returns, the floor protects you from losses.