By Wade H. Mayo, President, Life Insurance Company of the Southwest, member of the National Life Group

Overall, indexed annuities are relatively simple to understand, but figuring out how your interest rate will be credited can take some time to wrap your head around.

On a traditional fixed annuity, the issuing company declares an interest rate in advance for a class of policies, and the company then credits that declared interest rate to them. In contrast, the interest credited to an indexed annuity policy is determined by a formula spelled out in the policy. The formula states the index to be used (for example, the S&P 500 Index) and the specific way that interest will be calculated. The variables of the formula are declared annually in advance of the policy year, and the results of the formula are determined at the end of the year.  So the policyholder knows in advance  the exact formula for interest and finds out the result at the end of the year.

For example, the formula might call for interest based on 70% of any increase in the index in a policy year, with a cap (maximum interest) of 7% and a floor (minimum interest) of 0%. Assuming the index goes up, say, 12% during the period, the interest credited will be 7% (70% of 12% or 8.4%, subject to the cap of 7%).

In another example, the issuing company is to pay 100% of the increase in the index, limited to a maximum of 6%. The issuing company would declare a 100% index (participation) rate and a 6% cap. At the end of the policy year, results are determined from the stated formula. If the S&P 500 index increases, the policy will be credited with the percentage increase in the index — up to the maximum of 6% interest. If the index had gone down over the policy year, the annuity owner is not credited with any interest during that period.

An indexed annuity may limit the amount of interest that may be credited in certain rising markets but always guarantees against loss of premiums paid and earned interest in a market that declines over the measuring period.

Note that while the company annually decides on the variables in the interest rate crediting formula spelled out in the policy, the company does not control the results of the formula; that is determined by the change in the index.