Crediting Options for Index Annuities Explained

The Indexed Annuity market is very convoluted and voluminous. As mentioned in a previous article (Goldilocks Syndrome), the insurance companies design them to have something unique, so to differentiate themselves from other products in the market. By definition, they are challenging to understand, but once you get the basics down, you will find them to be much simpler than you would expect.

The term “Indexed”, refers to market indexes, and they could be stock market or bond markets, US or International markets, precious metals markets, or even “reverse trigger” indexes, that perform, based on a contrarian bases, or when the market goes down. At the advent of this concept, the first products available were primarily based on the S&P 500 Index. After close to 20 years of evolution, there are now products that use a variety of choices, from the Hang Seng Market in China, to the London Gold Market Fixing Price Index.

The choices have been added to offer options, not necessarily to improve the products. You should not be confused by all the alternatives because they all primarily work the same way. The client earns a percentage of the gains in an index, or the full amount of the gains, with a cap, or maximum.

All the products have some sort of, “limiting the gains provision”, because they mostly have floors, or preservation of principal, features.

Regardless of the Index chosen, these are all based on “markets”, so there is no best choice. No one has a crystal ball, so if anyone attempts to tell you which Index is best, run – don’t walk – away as soon as possible. There are software programs available that can “back cast” or look back, at historical Index performances, but it is not possible to determine which market will outperform another one, at any given time. Markets, by definition, go up and down, the problem is, you never know when, or how much!

Multiple choices allow for more diversification, and should be viewed that way. Don’t be misled to think that more choices mean it is a better product.

Crediting Methods

There are various methods used for crediting. I will go through the most common; but remember, companies are always looking to be unique – so be aware of a changing landscape.

Annual Point to Point

This method is probably the most common. It is exactly what it says, point to point, and credited annually. You start at a point in time, usually when the contract is funded, to determine the starting index number; and then, at the same date in time one year later, the index number is recorded again. The company looks at the two index numbers and determines if there was a gain. If there was no gain, there is no increase in value credited. If there was a gain, then the maximum cap, or participation percentage, is applied, and then credited.

Monthly Point to Point Aggregate 

This method is widely used as well. It works similar to the annual point to point to point, but here, we go from month to month, instead of year to year. Each month the index is measured and determined whether there is a gain or a loss. The “caps “are then applied to the gains, but there is no floor applied to the monthly losses. Then at the end of the policy contract year, the monthly gains and losses are added up in aggregate. If the sum total is a negative, then nothing is credited to the contract. If there is a gain, that percentage is applied to the contract value.

Monthly Point to Point: Daily or Monthly Average 

In this method, the monthly or daily index numbers are recorded, and then added up at the end of the year. The totals are divided by the number of days, or months accordingly, and that average is typically limited by a “participation percentage”.  The participation rates on these methods have increased recently, so they have become more appealing.  This approach is typically a more conservative method, in that they tend to earn less in strong up markets, but perform better in down markets.

Bi- Annual, Three, or Multi-Year Point to Point

These methods are becoming more common, because they seem to generate higher returns than their annual, or monthly, counter-parts, over a longer than one year time frame. That is not to say it is a better choice. The issue here is, that the timeline is longer, and needless to say, more time between crediting, adds volatility. Looking at past history is a good evaluator, not a predictor, but from that perspective, longer timelines seem to outperform the shorter timelines.

With that said, the longer increments, may end up more popular than the shorter ones, but care must be taken in matching crediting timelines, with the individual’s circumstantial needs.

Bottom Line

The most important point to consider when evaluating a product or after choosing a product, selecting a crediting method, is that there is no “magic bullet”! Depending on how you evaluate the history, you could reach different conclusions on which method out performs the others. Which day of the month, which year, and which month of the year you begin with, could change the returns you receive, dramatically.

Diversification can always be used to mitigate lower returns in any one year, so it is never a bad idea to consider spreading your money around in different options. But keep in mind, the goal of achieving a good return, with safety, is the objective of these tools.

If you use these products, in conjunction with a strong guaranteed income rider, or death benefit rider, then you have the opportunity to be more aggressive than you normally might be. Having a guaranteed income safety net, and knowing that your principal is always protected, allows you to take advantage of the upside of these products.

Certainly, a longer time frame to work with is important for a better chance of good returns; but isn’t that what the goal of a strong annuity is in the first place? The annuity products were designed many years ago, for strong, safe, long term income. This contemporary version of the old standby does that, but with liquidity the original annuities never had!

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