How do annuities make money?

By Cathy DeWitt Dunn

Annuities are popular retirement planning vehicles where a large principal payment is held with an insurance company. In exchange, the insurance company pays regular sums over a predetermined period of time. Steady income generation can make fixed index annuities a valuable part of retirement portfolios. A fixed index annuity (FIA) is a twist on the traditional annuity styles. How are they different? An FIA adds market-based growth on top of the base fixed interest rate for your annuity. (Remember, the fixed interest rate is provided over a specific term with principal guarantees).

This setup means that fixed index annuities can earn extra value when the market performs well. A fixed index annuity provides more earning potential by tracking indices like the S&P 500. You earn more when the market is doing well. But you still earn the minimum guaranteed rate when the market downturns. But how do annuities make money? We explain three methods for annuity payouts below.

Crediting Methods

Insurance companies use one of several different crediting methods to determine how much to pay each period. The chosen method is usually outlined in the annuity contract and stays the same throughout the life of the annuity. Some contracts others permit more flexibility and provide the opportunity to change or adjust on a semi-regular basis. Each crediting method has pros and cons depending on overall economic activity.

Annual Point-to-Point

Annual point-to-point crediting accounts for growth based on the amount of interest earned on market gains over the course of a 365-day period. An annual cap for this amount is generally included in an annuity contract. For example, if annual interest gains are at 12% and an annuity’s cap is 10%, only 10% will be credited. This method is best in times of high volatility, when markets may rise and fall, but the likelihood for net positive growth over a year is still high.

Monthly Point-to-Point

Monthly point-to-point crediting relies on monthly index performance rather than annual. This method is subject to a monthly cap. At the conclusion of the year, each month’s returns are added up and applied to the balance of the account, if the market had a positive overall performance for the year. As a result, this method is best for when the market is rising steadily over months or years. 

For more see >> Point to Point Annuity Crediting Method

Monthly Average

The monthly average approach takes the average over 12 months of growth. Then determines the mean value for the year. This growth is added to your principal and contributes interest income to your annuity. Like most other annuity crediting methods, there is generally a cap on gains. The monthly average method can still provide a payout in years with significant shifts.

For more see >> Retirement Annuity Monthly Average Crediting Method

We hope that this article has helped you answer the question: “How do annuities make money?”. A fixed income annuity may fit your portfolio perfectly. Ask yourself:

• Am I looking for guaranteed future income?
• Do I still want to receive gains when the market doesn’t do well?

Consider taking advantage of market activity in your annuity portfolio, without risking your principal. The right annuity may offer you stability, consistency and growth potential throughout retirement.

Related Articles from DeWitt & Dunn Financial Services and Annuity Watch USA

• Fixed Index Annuities for Retirement
• Annuity Rates

Disclosure: For informational and educational purposes only. The information contained herein may contain information that is subject to change without notice. Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor.

Guarantees and benefits are subject to the claims paying ability of the issuing insurance company.

Indexed annuities are insurance contracts that, depending on the contract, may offer a guaranteed annual interest rate and some participation growth, if any, of a stock market index. Such contracts have substantial variation in terms, costs of guarantees and features and may cap participation or returns in significant ways. Any guarantees offered are backed by the financial strength of the insurance company, not an outside entity. Investors are cautioned to carefully review an indexed annuity for its features, costs, risks, and how the variables are calculated. A fixed annuity is intended for retirement or other long-term needs. It is intended for a person who has sufficient cash or other liquid assets for living expenses and other unexpected emergencies, such as medical expenses. A fixed or indexed annuity is not a registered security or stock market investment and does not directly participate in any stock or equity investments or index.