Index Annuity Crediting Methods
Since their introduction in late 1995, indexed annuities have enjoyed great popularity. Like there fixed counterparts, indexed annuities credit holders with an interest return. This rate is not fixed according to a period stipulated in the annuity contract. Instead, it is tied to a financial market index, probably an equity-market index such as the Standard & Poor’s 500 index of stocks.
Why Go Through the Insurance Company?
The annuity holder could purchase the index contract directly or perhaps buy an option on it, rather than transact through an insurance company. A market index is an average of market prices and thus is less variable than individual prices or subsets of prices. Still, equity-market indices can be quite volatile, as recent experience attests. The role played by the insurance company is to lessen this volatility and thus (appropriately enough) reduce the investor’s risk. This is done by offering the annuityholder either a guaranteed minimum rate of return (normally zero) or a guaranteed positive return or range of returns (typically somewhere between one and three percent), or both. These guarantees may apply to each individual year of the contract or only over the entire contract term.
How Does the Insurance Company Make Money?
Whenever an insurance company contracts to provide benefits, the company must invest in order to create the wherewithal to pay the benefits. By definition, the insurance company is assuming risk that would otherwise be borne by the insured. To insure payment, the investment should be geared as specifically as possible to the nature of the risk assumed. In this case, the insurance company has agreed to pay the annuityholder a return tied to the performance of an equity index, but to indemnify the holder against declines in the value of the index. The logical way to satisfy its obligation is for the company to itself purchase the index. That way, it will use index gains to satisfy its obligation to compensate the annuityholder.
Two questions immediately arise. How is the insurance company compensated for its services? What happens if the index declines? The insurance company solves both of these problems with one stroke. It credits the annuityholder with less than the full value of gains in the index, pocketing the difference between the actual index performance (which also includes dividends) and the credited return. This difference pays the insurance company’s costs and adds a profit. Technology improves year by year and never declines; this guarantees that in the long run overall company productivity will rise and produce profits. This means that there will be more index gains than losses. This excess of gains over losses allows the insurance company to offset index losses in bad years with gains in good ones.
The Purpose of Indexed Annuity Crediting Methods
The purpose of indexed annuity crediting methods is to provide a formula for determining the amount of index gain credited as interest to annuityholders. Although the rationale is straightforward enough, the execution is anything but simple. Since 1995, over forty different crediting methods have been devised by over fifty insurance company offering indexed annuities, resulting in nearly two hundred different variations in this product. All of these different methods have in common the idea of lowering the credited index gain to the annuityholder below the actual gain achieved by the index. (Subject to the conditions noted above, holders are shielded from index declines, which are absorbed by the company.)
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The Major Categories of Indexed Annuity Crediting Methods
The first step in calculating the credited return is to calculate the gain in the index. There are four major categories of methods for doing this among indexed annuities. They are:
- Annual reset – This method is the most familiar to the general public because it most closely corresponds to the way that interest is usually paid. The index number value at the beginning on the contract is compared to the index number value one year from that date. Interest is credited based on the percentage increase (if any) in the index. The same procedure is followed in each succeeding year of the contract.
- Point-to-point – The index number value at the beginning of the contract is compared to the value at the end of the contract term. Interest is credited only once, based on the percentage increase between those two points.
- High water mark – Interest is credited only once, at the end of the contract, based on the percentage increase between the beginning index number value and the highest index number attained over the course of the contract term.
- Averaging – Index number values taken at different points over the course of the contract are averaged. These points may be daily, monthly or yearly. Interest is credited based on the difference between the beginning index number value and the averaged value(s) determined by the averaging process. Interest may be credited monthly, yearly or at the end of the contract.
The Role of Caps and Participation Rates
Once the index gain has been calculated, the next step is to reduce that gain to determine the credited return. One way to do that is by stipulating an interest cap, above which further index gains are realized by the insurance company, not the annuityholder. Another is by naming a participation rate, which is the percentage of the index gain credited to the annuityholder. Obviously, the maximum participation rate is 100%, which would allocate all gain to the holder. Either, both or neither of these tools may be used in conjunction with one of the four major index-gain calculation methods shown above.
An Example of an Indexed Annuity Crediting Method
Suppose that the annual reset calculation method is used in combination with an interest cap of 7% and a participation rate of 80%. The beginning index-number value is 100; exactly one year later, the index stands at 110. The index gain is 10%. The participation rate is 80%, reducing this to 8%. This is above the interest cap of 7%, so only 7% interest is credited to annuityholder accounts.
Which Indexed Annuity Crediting Methods Are Best for Annuityholders?
This question cannot be answered without knowing what course the indexed equity market will follow during of the annuity term. In general, the high-water mark method will produce the highest credited interest; however, insurance companies rarely use this method and when they do they combine it with low participation rates and/or caps. In a steadily-rising market, the point-to-point method will produce the highest credited interest among the other three methods. If only moderate increases are expected, a cap will probably be optimal, given a particular level of participation. Averaging methods are best in highly volatile markets, where averaging smoothes out the peaks and valleys of market swings.
What Should Annuityholders Do?
Does this mean that annuityholders must – or should – strive to guess the future course of the market covered by the index? No. There is no reason to believe that investors can successfully forecast the future value of stock prices. Consequently, the choice of crediting methods is probably random. Annuity purchasers should concentrate on areas where their choices are meaningful. The most important of these is the choice of issuing insurance company. No matter what the crediting method is, if the insurance company cannot pay the interest, the holder is in trouble. The annuityholder should first choose a sound company and worry later (if at all) about maximizing rate of return. Will Rogers’ famous maxim applies: “The return of my money concerns me far more than the return on my money.”
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