Why fixed indexed annuities have caps

By Jason Kestler

Kestler Financial Group, Inc.

Fixed indexed annuities base their interest crediting upon the return of a stock market index.

Many people wonder why, in a positive stock market year, fixed indexed annuities usually credit considerably less than the index return due to caps, participation rates, spreads, or some other element of the formula used to calculate the index credit. They wonder why the caps or other formula elements are necessary.

The answer is simple: In a negative stock market year, fixed indexed annuities eliminate the effect of the loss and provide immediate, total protection of your account value. That’s incredibly valuable protection, and that means it is expensive for the carrier to provide. It is the cost of the protection provided in a down year that prevents the carrier from being able to pass through all of the index increase in an up year.

The next question consumers often ask is, “Why does the carrier reserve the right to change the cap every year?”

The answer comes down to how carriers invest the money that has been entrusted to them by their customers. Carriers invest the money in a combination of bonds and option contracts. These option contracts can only be affordably purchased for one-year durations, and their prices can change dramatically from year to year. So, carriers sometimes need to change the caps in future years as the prices of the options they purchase change.

Keep in mind that fixed indexed annuities are not designed nor are they intended to replicate stock market returns. They are more comparable to other safer vehicles, such as bonds, CDs, and money market instruments. They are designed to offer consumers guarantees of principal yet also the possibility of higher potential interest credits than these traditional fixed interest rate products. Compared to that group of products, fixed indexed annuities offer very attractive potential returns.