Caps, participation rates and surrender charges, explained

If you are looking at a fixed indexed annuity, you will see a handful of terms again and again. Caps. Participation rates. Spreads. Surrender charges. These words decide two things: how much interest your contract can earn, and what it costs to get out early.

This article defines each one, shows how they work together, and lists the questions to ask before you sign. The numbers in the examples are made up to keep the math simple. They are not rates from any real contract.

The basic idea

A fixed indexed annuity is an insurance contract that credits interest based partly on how a market index performs. A market index is a published measure of a group of stocks, such as a broad index of large U.S. companies.

Your money is not placed in the index. You do not own the stocks. The index is only a yardstick the insurer uses to calculate interest. Washington’s insurance regulator describes these contracts as offering a minimum return plus a variable return tied to an index, subject to participation rates, caps, charges and other limits.

Interest is figured over a set stretch of time called the crediting period, often one year. At the end of each period, the insurer looks at the index, applies the contract’s limits, and credits interest.

The tradeoff, before the details

The limits below exist for a reason. In most of these contracts, if the index goes down during a crediting period, the interest credited for that period is zero, not a loss. That limit on the downside is paid for by limits on the upside.

So you give up part of the index’s gains in good years. In exchange, a bad year for the index does not reduce the value already credited to your contract. Fees for added features, or withdrawals beyond what the contract allows, can still reduce your value. Read the contract for how this works in yours.

Cap

A cap is the most interest your contract can earn in one crediting period, no matter how much the index rises.

Hypothetical example: your cap is 6%. The index rises 15% this year. Your credited interest is 6%. If the index rises 4%, you get 4% (assuming no other limits apply).

Participation rate

A participation rate is the share of the index’s gain that counts toward your interest.

Hypothetical example: your participation rate is 50%. The index rises 10%. Half of that gain, 5%, counts toward your interest.

Some contracts use a participation rate with no cap. Some use a cap with a 100% participation rate. Some use both.

Spread

A spread (also called a margin or asset fee) is a percentage subtracted from the index’s gain before interest is credited.

Hypothetical example: your spread is 2%. The index rises 7%. Your credited interest is 5%. If the index rises only 1%, your credited interest is zero, because the spread is larger than the gain.

How they stack together

When a contract uses more than one limit, the order matters. Your contract spells out the order. Here is one hypothetical way it could work:

1. The index rises 12%.
2. A 75% participation rate makes that 9%.
3. A 7% cap limits it to 7%.
4. Your credited interest for the period is 7%.

These rates can change

This is the part many people miss. In most contracts, the insurer can change the cap, participation rate or spread over time, often at the start of a new crediting period. The annuity disclosure at the bottom of this page says so too.

What does not change is the minimum your contract allows. A contract may state the lowest cap, the lowest participation rate, or the highest spread the insurer can ever use. Those minimum terms are usually less generous than the starting rates. Ask to see both.

Surrender charges

A surrender charge is a fee the insurer keeps if you cancel the contract, or take out more than the contract allows, during the surrender period. That period is the stretch of years when the fee applies.

Washington’s regulator says surrender charges are usually 5% to 10% of the amount you take out, highest in the early years, and that insurers can charge them for an average of about seven years. Your contract will have its own schedule.

Hypothetical example: you take $10,000 out of the contract in year two, above what the contract allows without a charge. The schedule shows a 7% charge in year two. The insurer keeps $700.

Why does this fee exist? The insurer plans for your money to stay with it for years. The surrender charge helps it keep its promises to you and to other contract owners if people leave early.

Penalty-free withdrawals

Many contracts let you take out part of your value each year without a surrender charge. This is often called a penalty-free withdrawal or free withdrawal amount. The contract states how much and how often. Taking more than that amount can trigger the surrender charge on the extra.

Market value adjustment

Some contracts also have a market value adjustment, or MVA. If you take out more than the free amount during the surrender period, an MVA can raise or lower what you receive, depending on how interest rates have moved since you bought. Not every contract has one. Ask.

Taxes on early withdrawals

Separate from any surrender charge, the IRS may add a 10% additional tax if you take taxable money out before age 59½, unless an exception applies. IRS Publication 575 explains the rule. For how it would apply to you, talk with a tax professional.

Questions to ask before you sign

Bring this list to any conversation, including one with us:

• What is the cap, participation rate, and spread today?
• What are the minimum terms the insurer can never go below?
• How often can the insurer change these rates?
• Does the index measure include dividends paid by the companies in it, or only price changes?
• What is the surrender charge in each year, and how many years does it last?
• How much can I withdraw each year without a surrender charge?
• Is there a market value adjustment?
• Are there fees for any optional features (called riders)?
• How long is my free look period to return the contract for a refund?

Washington’s regulator also suggests comparing similar annuities from several companies and asking for and reading all disclosures. The NAIC Buyer’s Guide for Deferred Annuities is a free, plain-language guide written by state regulators. It is worth reading.

The bottom line

Caps, participation rates and spreads limit how much interest you can earn. Surrender charges limit how easily you can leave. Those limits are the price of the floor under your credited value. Whether that price is fair depends on your timeline, your other money, and what you want this money to do.

If you want to compare this kind of contract with a simpler fixed annuity, read fixed vs. fixed indexed annuities. And if you are not sure an annuity fits at all, start with when an annuity is not right for you.