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calculating
interest annual reset
yield
spread averaging
caps |
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Calculating Interest
TopAnnual Reset Top
| Let’s say that an index annuity said it would
credit 50% of any positive index movement at the end of the contract year;
we’ll also say that the index level is 1000 today. One year later the
index has reached 1140. The way this works is the beginning index value is
subtracted from the ending index value (1140-1000 = 140) and the
difference is divided by the beginning value to determine the percentage
of index movement (140/1000 = 0.14).
We said our index annuity participates in 50% of any positive movement , so we multiply the percentage of index movement by 50% to determine the actual interest earned by the annuity which is 7%. |
How Index Annuity Interest Is Calculated x 50% Participation Rate 7% Interest Earned
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What if the index difference had been negative? If the index difference is negative it is treated as a zero movement.
This example shows the way an annual point-to-point crediting method works. The insurance company says in advance to what extent the index annuity will participate in the coming year’s index movement. This “participation rate” is applied to any positive movement produced by the index.
Yield Spread
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The participation rate can be expressed as a percentage, like the 50% figure
used, or we could deduct an “asset fee” or “yield spread” from the index
movement to determine actual interest credited to the index annuity.
Instead of saying that it will credit interest equal to 50% of any positive index movement the insurer could perhaps say that 100% of the index movement minus a 4% “asset fee” . If the index movement was 11% deducting a 4% fee would give us 7% interest - the same interest as with the participation rate. However, if the index movement were higher or lower, the two methods would yield different results. Also if the index movement was 4% or less, so that subtracting the fee generated a zero or negative interest, the interest would be zero.
Whether the interest would be expressed as percentage of index movement or a yield spread, a key point to remember is that the insurer is not keeping the 4% asset fee or retaining the 50% portion after crediting a 50% participation rate.
Averaging
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Let’s say that over the next year the index closed every four weeks
with the values we’ve listed below. Although we ended the year at 1100, if you add
up all the monthly values and divide by 13 you get an averaged ending value of
1070.
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How Index Annuity Interest Is Calculated Beginning Value 1000 1070 Average End Value |
Averaging always drive numbers to the middle. In a generally rising market averaging usually produces a lower value than an actual end point; in a falling market averaging generally produces a higher ending value than an actual end point. If you think the index will be rising over the next year - and averaging produces a lower end value in a rising market than an actual ending point, then wouldn’t you always want to go with the non-averaged crediting method? The answer is, it depends. A crediting method using averaging usually has lower option costs than an annual point-to-point method. Lower option cost means that more options can be purchased so a higher participation rate can be offered. Our annual point-to-point method recognized an index gain of 14%, but due to the higher option cost participated in 50% of the positive index movement, so 7% interest was credited. The monthly averaging method only recognized index movement of 7%, but due to the lower option cost was able to participate in 100% of this movement, so 7% interest was credited. |
If you don’t use averaging in an index formula you will
either have a lower participation rate
and/or need to use a cap to limit gains.
The examples produced identical interest to keep things simple. In the real world interest earned by different crediting methods may vary widely each year depending upon index movement and financial market forces.
Index annuities that average index values may require a little more education on the agent’s part in explaining how they work. An averaging structure means that values are always driven towards the middle. This means in a rising market averaging can produce a lower gross return than the index in general and in a falling market averaging can produce a higher gross return than the index in general.
If you don’t use averaging in an index formula you will either have a lower participation rate and/or need to use a cap to limit gains. Caps and averaging reduce the cost of the option strategy and permit you to have a higher participation rate (or a lower asset fee or yield spread). Averaging can produce higher gains than other methods when you have corrections near the end of the period or lower gains if the market spikes at the end of the period.
Caps Top
There’s one other variable that index annuities may use and it’s called a Cap. A Cap is a ceiling or upward limit on the interest that may be credited. A Cap usually reflects the maximum interest which can be credited to the annuity contract - an Interest Cap of 12% would mean that regardless of index movement the maximum interest credited for any one period is 12%. A different type of Cap is an Index Cap which limits the amount of index movement to which a crediting method is applied - an Index Movement Cap of 12% would mean that any index movement above 12% is ignored.
| Index Annuities may calculate interest
crediting by using a participation rate, a yield spread, or a
combination of both methods, and a cap may or may not be used.
Because caps limit the maximum interest that could be credited to an index annuity the annuity buyer could feel they are missing out on potential gains. However, a cap on interest may help the annuity produce higher earnings. |
Interest 15% Index Movement Is 9%<12%; Yes |
Cap
12%
30% Index Movement Is 18%<12%; No |
Index annuities usually buy options on the index to create the potential for excess interest beyond the minimum guarantee. The sellers of the options have to pay off at whatever the market level is when the option matures, so the sellers bear the risk of a rising market. If the market only goes up a little, or if their exposure to market gains is limited, the sellers pay out less money. If they sell an option without an upward limit the sellers demand significantly more dollars for the option because they have substantially more risk. If the insurance companies have to pay more for options they can’t buy as many, so the participation rate they credit is lower.
Putting a cap on the potential increase in the value of the option means that the sellers have less risk, so a lower price is charged. Lower option prices means that the insurance company can buy more options and offer a higher participation rate.
So, placing a cap on potential gains means the participation rate should be higher for the capped product than for the annuity without a cap. If index gains are modest the capped version will credit more interest. Which annuity will credit more? It depends on the relative rates and how often the interest ceiling is actually exceeded.
Say that one point-to-point annuity had a rate of 55% with no cap and another offers a 100% rate, but will credit a maximum return of 11% for the coming year. What this means is that in any year when the index growth exceeds 20% the non-cap annuity will produce a higher return. We determine this point by dividing the cap (11%) by the non-cap rate (55%). Conversely, whenever the index gains less than 20% the EIA with a cap will have the higher return.
| Index Gain | x 55% | x 100% w/ 11% Cap |
| 22% | 12.1% | 11% |
| 21% | 11.6% | 11% |
| 20% | 11.0% | 11% |
| 19% | 10.5% | 11% |
| 18% | 9.9% | 11% |
So which is best? If you plug in these rates and caps into the last fifty years and figure out the average hypothetical return for the methods over all of these years the average returns are virtually identical!
Cap or No Cap the returns were identical over time
Any crediting structure can produce the highest return in a given market and our studies show that all crediting structures have delivered very respectable returns overall. Whether an index annuity with a cap on the return will result in more interest credited than one without a cap depends on the movements of the index, the ceiling on the interest credited and the relative participation rates of both products.
Compound Interest Top
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Suppose you had $1 and someone gave you a choice between earning 10% calculated as simple interest or 9% calculated as compound interest. Which one do you choose? It depends on how long you’re going to leave your money at work. |
At the end of one year the simple interest method would add a dime to your initial dollar and you’d have $1.10. The compound interest method would add nine cents and you’d wind up with $1.09. If you’re only looking at one period there’s no difference between simple and compound interest.
If you went out two years, the simple method would add another dime to your $1.10 giving you a balance of $1.20. Simple interest means that interest is only earned on the original principal.
Compound interest works a little differently. Compound interest multiples the previous balance - in this case $1.09, by the interest rate (9%), and adds the numbers together to determine a new value.
So, $1.09 multiplied by 9% produces not 9 cents but 9.81 cents. This is added to the previous balance (1.09 + .0981) to produce a second year total of $1.1881. A short hand way to figure the results of compounding is to put a one in front of the interest rate ($1.0 x 1.09 = $1.09).
At the end of five years the simple method would have produced
a total of $1.50
($1+ 0.10+ 0.10+ 0.10+ 0.10+ 0.10).
But, the compound method generated $1.54
($1 x 1.09 x 1.09 x 1.09 x 1.09 x 1.09).
If you’re only looking at a few periods there isn’t a lot of difference between the effects of simple and compound interest. However, the benefits of compound interest become proportionately greater with each passing period.
Where's The Risk?
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Index annuities provide the protection of other fixed rate vehicles, but with
potential for excess interest earnings beyond the minimum guarantee.
What about the risk?
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Both stocks and mutual funds offer the potential for gains, and long term investors in these vehicles have realized average returns that are higher than safer alternatives - but these vehicles have market risk. The stock market goes up and down and on any given day these investments may be worth more or less than originally paid. Index annuities eliminate this market risk on principal. When a customer buys an index annuity their principal is backed by, and is as safe as, the insurance company that issued the annuity. As with all fixed rate insurance products index annuities provide a minimum guaranteed return. Excess interest beyond this minimum guarantee is calculated based on movements on an external index, but the customer is not directly involved in buying the investments. The insurance company is also insulated from risk when they buy options on the index and not the underlying securities. An option gives you the right - not the obligation, to buy or sell something within a period of time. Buying bonds to protect the minimum guaranteed return, and options to provide excess interest potential, is a very conservative financial strategy. The primary risk is that due to the uncertainty of future index movements an index annuity may not produce interest earnings comparable with other savings vehicle and may indeed only meet the guaranteed minimum return. |
Where’s The Risk? Market Risk Option Risk If you have an option to buy a stock If the stock goes higher than $50
you still have the right
to buy the stock at $50, Principal Risk Even if the stock market crashes the customer is not at risk for market losses. |
Annual Reset Annuities Reset (Annually)
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Most of the index annuities on the market calculate index movement for a one
year period and then credit interest to the index annuity contract applying a
crediting formula to any recognized gain. If there isn’t a gain the contract
simply credits zero for the year, but previous interest credited is
unaffected. The process then begins again using the actual end of the year
index value as the starting point for the coming year. This is the basic
structure for annual reset index annuity products and it is easy to
understand. However, the simplicity of the index annuity structure doesn’t
portray the real power of the index annuity story.
The index annuity locks in the annual gain. The gain cannot be lost even if the index subsequently goes down. This is a very important feature. Equity investments have produced significantly higher returns over time than fixed rate vehicles. Based on the past performance of equity investments why doesn’t everyone buy stocks? The reason is that stocks can go down and you can lose money. Index annuities are designed to give the potential for higher returns than other savings vehicles, but without the market risk to principal associated with stocks. In today’s financial markets annual reset index annuities are crediting effective net rates of around 50% to 60% of the actual index gain. At first glance, participating in only around half of an index yearly gain seems low and unappealing - especially when compared to pure equity investments. However, you need to remember that these annuities ignore the bad years.
Suppose we had a five year period where the index acted like this:
| Index Gains | Participation Rate | Annuity Gains | |
| Year 1 | +20% | x 50% | 10% |
| Year 2 | +16% | x 50% | 8% |
| Year 3 | +12% | x 50% | 6% |
| Year 4 | -20% | x 50% | 0% |
| Year 5 | +14% | x 100% | 14% |
Suppose during this same period the index annuity was only able to participate in 50% of the index gains for the first four years and then was able to offer a 100% effective participation rate in the fifth year. The credited rates would look like the Annuity Gains posted above:
If we placed $10,000 in the index and $10,000 in the index annuity, here is what the accumulated values would be at the end of five years:
| Index Value | Annuity Value | |
| Year 1 | $12,000 | $11,000 |
| Year 2 | $13,920 | $11,880 |
| Year 3 | $15,590 | $12,593 |
| Year 4 | $12,472 | $12,593 |
| Year 5 | $14,218 | $14,356 |
Even though the annuity only offered a 100% rate in one year it still performed comparably. The reason is because the index investment fully participated in the fourth year loss; the index annuity was not affected.
My example was designed to show comparable results. In reality, equity investments should produce higher returns over time than index annuities because in today’s markets an annual reset index annuity cannot provide full index participation, but the difference in performance between the two might be closer than we would think because of the “no market loss” feature of index annuities.
In 1999 the S&P 500 generated a 19.53% gain. In 1999 annual reset index annuities produced returns of 8.11% to 12.43% depending upon the crediting method. In 2000 the S&P 500 lost 10.14% producing a total gain of 7.41% for the two year period. The index annuities retained their 8.11% to 12.43% gains for the same period.
Another amazing feature of these annuities is that they reset. The S&P 500 fell from 1468 at the end of 2007 to 2008 at the end of 2000. If you had purchased the index in 2007 you would need it to increase 63% simply to be back where you started. But, the index annuity uses the lower ending value as a new beginning. Instead of merely struggling back to ground zero the index annuity is sharing in the increase.
Annual reset index annuities can capitalize on choppy markets by using slides to their advantage. At the end of 1972 the S&P 500 closed at 118 - a year end index level it would not again reach until 1980. If you could have purchased the index in 1972 you were under water for the rest of the ‘70s. However, an annual reset structure over the same period would have recognized a 77.9% gain.
Index annuities are an extremely powerful financial tool. Index annuities provide the protection of other fixed rate vehicles, but with potential for significantly higher returns. Although they are not designed to compete with equity investments index annuities may, over time, provide more competitive returns than expected and with a lot less stress to the nerves.
All information is for illustrative and educational purposes only, does not provide investment or tax advice, and is not an inducement to buy or sell anything. Information is from sources believed accurate but is not warranted. Advantage Compendium neither markets nor endorses any financial product.