The great thing about Indexed Annuities is that they let the owners participate in the gains of the stock market but not in the down trends of the market. When the market goes up, an indexed annuity credits a portion of that upward move to the owner, in the form of an interest payment, but when the market goes down the annuity will hold it’s last “locked in” value.

Indexed annuities came into existence in 1995. They are considered a fixed annuity because they guarantee that you cannot lose money, in most cases they even guarantee that you will make at least a little money. They also guarantee that once earnings are credited to the account you can never again lose that money either. It’s that last part of the guarantee that makes these contracts so unique and valuable. It is also the part that helps the returns on these contracts keep pace or even ahead of other popular investments.

## Too Good To Be True

If you are like me you are probably thinking right now that this sounds too good to be true and therefore it probably is just that. However, if you will read through this part you will come to understand the mechanics of the investment vehicle and then understand how indexed annuities can and do work exactly as described.

Let’s say you invest $100,000 into a fixed indexed annuity, lets further say that the insurance company guarantees that at a minimum they will pay you 1.5% interest on 90% of the money over the next 10 years. That means they are guaranteeing that at the end of 10 years they will cash in your policy to you in the amount of $114,448, (that’s your original $100,000 plus the accumulated, compounded interest on 90% of the money). Now let’s assume that the insurance company actually is making 5% on the money they manage. Since they are only paying you 1.5% on 90% of your money that is the equivalent of paying you 1.35% on all the money. The insurance companies work on about a 2% margin meaning that is what they have to earn on their investments to pay all their bills. This is much lower than banks because they only have a fraction of the employees or buildings that banks do.

Anyway, if we take the 2% away from the 5% that they are actually making that leaves them making 3% on your money that they could pay you, but they are only guaranteeing you the 1.35%. This is what frees up the money to make the indexed portion of this investment work. Since they are guaranteeing you that at the end they will cash you out at $114,448 and they are actually making 3% with your money they only have to invest approximately $85,000 to fulfill the guarantee ($85,000 compounded at 3% for 10 years equals $114,232). Therefore the insurance company now has about $15,000 to buy options on the S&P 500 with. An option is a right but not an obligation to buy something at a given time at a given price.

So to put this altogether now. The insurance company takes the $15,000 and divides it into 10 portions so that they can buy the options every year for the next 10 years. Now on a yearly basis the company buys options on the S&P 500. If the market goes up the company will exercise the option and credit your account with the earnings. This is why we do not get the total upward move of the market, the options cost money and sometimes there is not enough money to buy enough options to cover 100% of the move. On the other hand if the market goes down, then the option expires worthless and all that is lost is the money used to buy that years option. That way the guaranteed portion is still in tact and the money for the following years options are available. Hence when the market goes up the indexed annuities make money but when the market goes down the indexed annuity retains it’s last credited value.

The following chart shows the comparison of $10,000 invested directly into the market as opposed to putting it into an indexed annuity that is tied to the performance of the market but not invested directly into the market.

Sample $10,000 account | |||

Year | Percentage | S&P 500 Mutual Fund | S&P 500 Indexed Annuity |

60% Participation no Cap | |||

Start | $10,000 | $10,000 | |

1 | 10% | $11,000 | $10,600 |

2 | 15% | $12,650 | $11,554 |

3 | -8% | $11,638 | $11,554 |

4 | -8% | $10,241 | $11,554 |

5 | 20% | $12,290 | $12,940 |

These numbers are completely fictional and are just being used as an example to show how NOT participating in the down turns and only participating in 60% of the upward movements can still produce excellent results.

There are many phrases that are very unique to this product and the following will introduce and explain those to you..

#### PARTICIPATE IN THE GAINS OF THE MARKET:

There are many methods by which insurance companies can determine how they are going to determine how much interest to credit to an indexed annuity product. We will discuss here some of the most popular methods.

#### MOVING PARTS:

It’s the “moving parts” that make it so hard to understand indexed annuities and compare them against each other. There are three basic moving parts and they can be used either singularly or in combination with each other. The three parts are: Participation rate, Caps and Margins (sometimes called spreads).

#### PARTICIPATION RATES:

This is usually used in the “point to point” methods. They are always stated as a percentage. Some examples would be 55%, 45% or 60% and what they mean is that if the market increased by 10% over the specified time period, you would get the percentage of the participation rate stated. So if you had a 60% participation rate your contract would be credited 6% for that time period.

#### CAPS

Caps are upper limits of the amount of interest that can be placed on any of the crediting methods. In other words even though your crediting method, because of the upward movement of the market, shows that your potential profit for the year might be 12% if your cap is 6% then all you will earn for that year is the 6%. If the cap was 11%, you would earn 11%. If the cap was 13% you would earn the 12%. One method Monthly Sum which you will read about a little further down, uses a monthly cap, usually 2% to 3% so as you can imagine the potential for those contract is quite large. Don’t get too excited till after to read that full explanation.

#### MARGIN OR YIELD SPREAD

This is the easiest to understand. It simply means that you will get 100% of the move of the market less a yearly set percentage rate. Let’s say the yield spread is 3%, if the market does 10% for the year you will get 7%. Of course this also means if the market does 3% or less you will not get any interest credited to your account for that year. As always there is a minimum guarantee of earnings over the life of the contract and you don’t get charged the yield spread if the market goes down, so you still can’t lose money with these contracts.

#### ACTUAL CREDITING METHODS

*THERE ARE 3 MAJOR CREDITING METHODS AND OVER 40 VARIETIES OF THOSE 3
The 3 main crediting methods are: Monthly Sum, Monthly Average and Point to Point*

#### POINT TO POINT:

Point to point can be annual, monthly, bi-annual etc. This was the original method used by most insurance companies and is still used today. The way it is determined is they take the price of the S&P 500 is on the day the money is activated into the index. Then they take the price on the last trading day before the anniversary point to point term. They then subtract the ending number from the beginning number, take that answer and divide it by the beginning number. That gives you the percentage of change in the S&P 500 for that fiscal year. Then they apply the interest to the annuity according to the terms of the contract. They are, however, limited by what are called caps. A cap is the maximum that the annuity will pay in a given year. Over the last 15 years the caps have ranged from a low of about 4.5% to over 13%. The cap rate (maximum percentage rate) is determined by a number of factors the biggest being prevailing interest rates. (This should be understandable if you read the above section named “To good to be True”)..

#### MONTHLY AVERAGE

Monthly average means that they take the S&P 500 or some other index, list the number that it was on the first Friday after the money went into the annuity. Then they list where the index is approximately every 30 days after that. This is done every month for the next 12 months. At the end they add up all the numbers, then divide that result by 12 to come up with what the average was over the 12 months. The next step is to subtract the average number from the starting number. The final step is then to divide that answer by the beginning number thus giving us the percentage of change, which then becomes the percentage of interest credited to your account, within the limits of the “cap”, which is the most common moving part with this crediting method. Note though that either one of the moving parts can also work with this crediting method. See example to the right.

#### MONTHLY SUM

Monthly sum subtracts the ending number of the index from the beginning number for each month and then figures out the percentage change for the index for that month. Then you add up the answers from all 12 months and add those numbers together. The difference with this method is that for one the “cap” is on a monthly basis and secondly you add up both the positive and the negative numbers to come up with the final number. It is well to note here that the cap only applies to the upside moves and not to the downside moves. This method works best in a fast rising market with no major down months. Also don’t look at just the Monthly sum subtracts the ending number of the index from the beginning number for each month and then figures out the percentage change for the index for that month. Then you add up the answers from all 12 months and add those numbers together. The difference with this method is that for one the “cap” is on a monthly basis and secondly you add up both the positive and the negative numbers to come up with the final number. It is well to note here that the cap only applies to the upside moves and not to the downside moves. This method works best in a fast rising market with no major down months. Also don’t look at just the upside potential. Although this method does well don’t forget the market has never gone up 12 months in a row.

#### Monthly Averaging Example with Actual numbers from 2010.

Index Value (rounded) nearest day to the 4th of month

2010 | |

Jan. | $ 1,133.30 |

Feb. | $1,064.40 |

March | $1,126.40 |

April | $1,187.60 |

May | $1,175.20 |

June | $1,068.82 |

July | $1,028.70 |

Aug. | $1,129.70 |

Sept. | $1,108.90 |

Oct. | $1,137.50 |

Nov. | $1,222.60 |

Dec. | $1,228.90 |

Total | $13,612 / 12 =”s $1,134.33 |

$1,134.33 – $1,133.30 =’s $1.03 | |

Return for the year | 0.09% |