What is the Participation Rate in an Annuity?

An annuity participation rate is the percent of any gain earned in a fixed-indexed annuity that is credited to you, the annuity holder. Only fixed-indexed annuities have this feature.

This means that if you are looking to add an annuity to help accumulate money before you retire or guarantee monthly income once you are retired, you should understand the nuances of each type of annuity.

Annuities are issued by life insurance companies and come in many flavors, including fixed, fixed-indexed, and variable. The rate of return on a fixed-indexed annuity (FIA) can be complicated, partially due to the concept of participation rates. Let’s dive into the details.

What Kinds of Annuities Have a Participation Rate?

Fixed-indexed annuities are the only type of annuity that features a participation rate. If you're including FIAs (sometimes simply called "indexed" annuities) as part of your overall retirement savings plan, you are likely looking for a little extra upside return versus a traditional fixed annuity.

Money deposited to a FIA contract is invested by the insurance company in whats called index funds that track the returns of a market index. The S&P 500 Index and the Russell 2000 Index are examples of market indexes that your annuity provider might use to grow your money. In some cases, you get to choose the index(es) where your money is invested.

If that index performs well, you get higher returns. If it performs poorly, you’ll receive lower returns or, in some cases, no returns.

Participation rates are the percentage of an index's returns that are credited to your annuity. Let's take a closer look at the concept of participation rates.

Understanding Participation Rates

Let's say that you buy an FIA and your annuity company invests your money in a specific index like the S&P 500. Assume that the annual gain on that index ends up being 7%. The insurance company collects the increase in value and will credit you a portion of the gain called the participation rate.

So if a FIA has a participation rate of 80%, then the index-linked returns would only amount to 80% of the actual gains associated with the index.

In the case above, you would be credited with 80% of the 7% gain, or 5.60%. The insurance company keeps the rest (1.40%) to pay for expenses such as investment costs, administration costs, etc.

The downside is that your ability to earn returns is limited by the participation rate. The upside is that you "participate" in the returns when they are positive, and the insurance company sets a minimum return that is almost always 0% or higher, so you can't technically lose money in a down market with an indexed annuity.

"Caps" and "Spreads" May be Applied Instead of, or In Addition to, Participation Rates

Fees applied to a FIA may be identified as caps and spreads in addition to, or instead of, a participation rate. These fees will be subtracted from any percentage gains linked to the annuity. For example, if the index gained 10% and the spread was 3.5%, then the gain in the annuity would be only 6.5%.

Similarly, the annuity company might set a maximum possible return, or "cap," per year on your annuity contract. For example, they might set the capped rate at 6% per year, even if the underlying index earns more. You earn 6% in this case, and the insurer keeps whatever remains.

If you are considering a purchase of a FIA or variable annuity, be sure to seek the advice of a trusted advisor. Understanding the total number and impact of possible fees in the form of participation rates, caps, and spreads will help you make a more informed decision.

For instance, you may want to ask your advisor what the historical net returns have been on the indexed annuity product you are considering. This can give you a better idea of the actual returns you might expect from the product.

The Impact of Surrender Charges

Deferred annuities are long-term savings products. You should only invest money that you know you will not need for several years. This is important because insurance companies apply surrender charges to annuities.

Surrender charges are penalties, represented as a percent of your annuity balance, that insurers impose if you withdraw funds during the surrender charge period. By having this protection in place, insurers are protecting their ability to earn a profit from managing your annuity.

When you purchase an annuity, you agree to a specific surrender charge period. This is the time period in which you cannot access your funds, except for some emergencies, which are spelled out in your contract. Some annuity companies also allow you penalty-free annual access to a portion of your balance (Canvas annuity allows up to 10% per year, for instance).

The surrender charge period can be as short as three years or as long as 14 years — it depends on your annuity contract terms.

Annuities with Participation Rates and Alternatives

When you are considering annuities as part of your overall retirement savings and income distribution plan, you may want to look at all three varieties of annuities or a combination that may make sense for you. Fixed annuities are the most conservative version, with low fees and a guaranteed rate of return. Canvas annuities offer some of the best fixed annuity rates in the country. Fixed annuities do not have participation rates.

FIAs, as mentioned, do offer the ability to earn more than fixed annuities, but that upside can be impacted by participation fees and declining market indexes.

Variable annuities offer the most upside potential since returns are linked to stock market performance. While these products don't have participation rates, they are loaded with fees that can impact your net returns. You can also lose money if the stock market does poorly.

Final Thoughts

Creating a plan to accumulate, then distribute money as part of your retirement strategy can be complex. Annuities can be an integral part of this strategy since they can offer solid returns before retirement and provide the ability to generate guaranteed monthly income in retirement.

Almost all retirement products have fee structures that must be well-understood before purchase. Annuities are no exception. That's why it's important to discuss these fees and the possible impact on your net returns before you buy.

Canvas annuities offer solid, conservative returns with no hidden fees. Canvas offers fixed annuities with guaranteed fixed annuity rates that are among the most competitive in the country. Since Canvas annuities are fixed products, there are no participation fees.