How Do Annuity Caps Work?
Equity indexed annuities are annuity contracts that pay interest on your savings based on the upward movement of the stock market. Only the upward movement of the stock market is counted for crediting interest to the account. All losses in the contract are ignored. These contracts are very attractive for some investors, but make sure you understand how the caps in these products work.
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Function
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The function of an annuity cap is to set a ceiling on the amount of interest that will be credited to the account in any given year. Caps are determined by the insurance company and are often changed over time. The caps change to reflect the insurer's cost of doing business and the ability of the insurer to pay its stated promises in the contract.
Significance
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The significance of an annuity cap is that it limits long-term growth in the contract. For example, if the annuity contract has a cap of six percent, then the maximum amount of interest that can be earned in the contract is six percent. This is regardless of how well the performance of the underlying stock index does.
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Benefits
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The benefit of an annuity cap is that the cap on the annuity eliminates the need for annuity contract fees. Annuity fees are another way that insurance companies are compensated for their investment expertise and are charged against the interest earned in the contract.
Disadvantages
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The disadvantage to an annuity cap is that earnings are limited. You will never receive the full growth in the underlying stock market index. This translates into lower income potential in retirement when compared to a direct investment into the stock market.
Considerations
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Consider whether a cap on your earnings would be beneficial for you over the long term. Annuity caps work best when the underlying stock index average returns are at or below the cap rate. This means that if the cap rate is six percent, the average indexed earnings should be no more than six percent. If stock market returns are averaging higher than six percent, consider a contract without an annuity cap.
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