How Index-Linked Annuity Interest Crediting Works

Index-Linked Annuity Interest Credit: How It Works Index-Linked Annuity Interest Credit, sometimes called "Interest Credits" are commonly used in permanent life insurance policies to reduce the total cost of an annuity. A typical scenario would be where a policyholder starts with a single life policy with $100,000 of coverage and deposits $10,000. The account credit amount is one-tenth of the initial deposit so in this case the account credit amount is $1,000. That means that for each year which passes without any withdrawals from the policy a credit will accrue for future interest crediting.

Index-Linked Annuity Interest Credit: How It Works How it Works Interest credits are a result of interest accruing on the account balance credited. In the above scenario, interest accrues every year and is credited to the annuity policy's account. The interest credit is added to a reserve account used to pay future policyholders' premiums.

Index-Linked Annuity Interest Credit: How It Works In addition to credits, there are negative credits which aren't covered in this article. Negative credits reduce the policy's premium for future years, but these negative credits don't affect the present value of an annuity payment stream as a whole. For the purpose of this article, we'll only deal with crediting interest.

Key Provisions of an Index-Linked Annuity The following provisions apply to the scenario outlined in the previous section:

Index-Linked Annuity Interest Credit: How It Works Base Rate The interest rate applied to deposits are known as base rates. As far as future crediting is concerned, every year which passes without a withdrawal from an annuity has interest credits added to the account's balance. Each year’s credit is calculated on the prior year’s base rate. In this example, the base rate is 10%. Each year’s credit is equal to a fraction where the numerator is the principal balance of the annuity account and the denominator is 365. In other words, the annual crediting amount is 1/1.1 = 0.90909090909… The interest rate applied to deposits are known as base rates. As far as future crediting is concerned, every year which passes without a withdrawal from an annuity has interest credits added to the account's balance. Each year’s credit is calculated on the prior year’s base rate. In this example, the base rate is 10%. Each year’s credit is equal to a fraction where the numerator is the principal balance of the annuity account and the denominator is 365. In other words, the annual crediting amount is 1/1.1 = 0.90909090909…

Index-Linked Annuity Interest Credit: How It Works Compounded Interest Compounding of interest means that interest credits accrue every year on an account's principal balance and continue to be added in this manner for as long as there are no withdrawals from the annuity.

Index-Linked Annuity Interest Credit: How It Works Premium Rate The annual rate applied to future payments or premium payments (whichever happens first) are known as premium rates. In this example, the annual rate is 10%. The rate for future payments is called the compound-interest premium and the rate for future premium payments is called the compound-interest premium.

Index-Linked Annuity Interest Credit: How It Works Coupon Rate The coupon rate applies to future policyholders' payments and is used to calculate how much of a premium reduction they will experience over time. If an annuity has a fixed sum payment, it will be simply a matter of finding the coupon rate and applying it to each year's interest crediting (we'll talk about fixed sums later). In this case, we’re interested in variable payments that can change from year to year.

Index-Linked Annuity Interest Credit: How It Works Fixed Sums Fixed sums are payments that a policyholder expects to receive each year. The amount is usually specified in the policy. For example, the policy may have a fixed sum of $10,000 per year and the interest credits will be based on the principal balance of the annuity account at the end of each year.

Index-Linked Annuity Interest Credit: How It Works Variable Payments A variable payment is simply any payment that varies from one year to another. The amount of each variable payment will be based on the policyholder's premium because this is what the policy specifies. For example, if a policy says that it provides payments ranging from $10,000-$30,000 per year then the policyholders' variable amounts will range from $10,000 to $30,000 every year.

Index-Linked Annuity Interest Credit: How It Works Fixed Sums: A Simple Example The following explains how interest crediting is calculated when there are both fixed sums and variable payments.

The following explains how interest crediting is calculated when there are both fixed sums and variable payments. Start with one single life policy with a $1,000,000 of coverage along with a $10,000 deposit. The base rate is 10% and the fixed sum is $10,000 so the crediting amount each year is 10% of ($1.0m - $0.1m) = 0.909090909… times $10,000 or 0.90909… × 10,000 = $9090 per year. Next we must figure out how much of this fixed sum goes into the variable payment stream by taking the standard premium amount and subtracting the premium for paying a fixed sum in addition to the fixed sum payment which we'll call fssp . In this case, the fssp is 0.909090909… and we'll use our example's standard premium of 10% so the variable payment is 0.90909… × 10% = $909.10 per year. At this point, we're done with the fixed sum stream but want to figure out how to calculate interest crediting on the variable payment stream.

Index-Linked Annuity Interest Credit: How It Works Fixed Sums: A Simple Example The following explains how interest crediting is calculated when there are both fixed sums and variable payments. Start with one single life policy with a $1,000,000 of coverage along with a $10,000 deposit.

Conclusion: The Annuity's Interest Credits Are Not Always Positive An annuity with both a fixed sum stream and a variable stream will always have some amount of interest crediting. The amount is based on the fixed sum stream and is always positive. However, if a policy provides both fixed sums and variable payments then it can have a negative interest crediting even if it has no future withdrawals. In other words, an annuity might actually be losing money due to this negative interest. If the annuity does have future withdrawals then its interest credits will be positive from year to year but level off somewhat over time.