Crediting Methods        Top   
Insurance companies use a variety of formulas to determine the excess interest that is credited above the minimum interest guarantee. Methods which calculate index movement over a period of one year are called annual reset structures and were discussed in Folio 4.  Methods examining index movements over a greater timeframe than a year or two are known as term end point crediting structures or term point-to-point structures.

Term End Point            Top   
A term end point structure measures index movements over a period greater than one year. Say that the index value was at 100 on the first day of the period. If the index value was at 200 at the end of, say, a ten year period the gross index gain would be 100% (200-100/100). The company would credit a percentage of this gain, by applying a participation rate. If the participation rate was 60% the index annuity would be credited with a total return of 60% interest (100% index gain x 60% rate) for the period.

What if the index difference had been negative? All index annuities provide a minimum guaranteed interest rate. If the interest earned from the index movement calculation is less than the minimum interest rate, then the guaranteed rate is used.

The total interest credited to the contract for the ten year period is 60%. A typical term end point index annuity only credits interest realized from index movements at the end of the term. Interest is not calculated and credited annually. Therefore, if the annuity owner surrendered the contract prior to the end of the term they would not usually receive any interest based on positive index movements. Most term end point annuities treat a death of the annuity owner as the end of the term and apply the participation rate calculation to the index value on the previous contract anniversary before the death.

High Point (High Water Mark)    Top     
This is a type of term end point structure that uses the highest anniversary index level as the end point. Say that the index value was at 100 on the first day of the period, reached a value of 220 at the end of a year during the period, and ended the period at 200. The company would use the 220 value - the highest point reached during the period, as the end point and the gross index gain would be 120% (220-100/100). The company would then apply a participation rate to the gain. No one has offered a true high water mark index annuity for years.

Guaranteed Rate versus Set Annually     Top   
When you buy any index annuity with a term end point crediting method the insurance company says in advance what percentage of the index movement the annuity will participate in for the term of the surrender period and this “participation rate” is applied to any increase in the index.  Annuities with annual reset structures may guarantee the rate for the entire term, for part of the term, or give the insurer the ability to change some aspect of the crediting formula (participation rate, yield spread, cap) on a yearly basis.

You can't simply pick the annuity with the highest participation rate

Which Is Best?        Top   
Since there are many variations in the interest crediting formulas used you can’t simply pick an annuity with the highest participation rate and assume you’ll get the highest return. Different crediting formulas react differently to different market conditions. The index annuity return is based on the actual movements of the index, the crediting formula and the participation rate applied. Because of this an index annuity with one structure at a 60% participation rate could produce a higher return than a different structure with a 90% rate.

In general, term end point structures should produce higher credited returns when the index is rising; annual reset structures tend to produce higher returns in mixed or choppy markets. But, any index annuity could deliver the highest return in given period depending upon these variables. In a prolonged bear market no structure will produce a high return, but the principal is protected from market risk.

Since we began tracking index annuity returns we've found that most annual reset structured annuities have delivered similar actual returns over this time. At first glance this may not seem possible. Some annual reset annuities had participation rates during the last five years as low as 30%; others had rates of 125%. Some annuities deducted a yield spread from returns while other placed a cap or ceiling on what could be earned. How could all of these different methods ultimately generate similar interest rates?

While there is a wide range between the nominal or stated rates of the different crediting methods the effective rates have a much narrower span.  The chart shows nominal or stated rates for different annual reset crediting methods over seven year periods. The far right column shows how much of the actual S&P 500 index movement is effectively captured if you apply the nominal rates over fifty years of index movement.

What this chart shows is even though the listed or nominal participation rates cover a wide range, if you plug the numbers into the last fifty years of index movement the effective rates and returns are very close. In other words, the returns would have been similar for all of the different crediting methods.  This makes sense when you realize that all insurers operate in the same financial markets with the same interest rate factors and option prices.

This doesn't mean that each year the returns from the different crediting methods are the same.  As stated, different methods perform differently in different markets.  

What Return Should I Expect?        Top       
Since index annuities have been available they have credited double digit interest rates when the stock market was soaring, modest rates when the market was uncertain, and protected credited interest when the stock market went down and others lost money.  No one knows where the market will head in the future, but the hope of index annuities is to provide the potential for a higher rate than one might earn from other savings vehicles that don’t subject the principal to market risk.

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.