An Overview of Crediting Methods of Fixed Indexed Annuities
Fixed indexed annuities (FIAs) are a valuable tool for retirement savings. They provide peace of mind by offering guarantees and safety of the principal amount. What’s more, they offer growth opportunity to help retirement savings keep up with the pace of inflation.
FIAs are distinct from other types of annuities in that the crediting methods differ. Regular fixed annuities credit interest at a rate that is linked to the T-bills rate. Fixed indexed annuities, on the other hand, credit interest using formulas based on changes in specific indexes. The crediting method determines how much interest is credited to the annuity. The rate and frequency of the credits depend upon the terms and conditions of FIA contract.
It is essential that you understand the type of crediting methods used by the insurance companies. Knowing how insurance companies credit interest in the FIA account will help you in choosing the right type of FIA that perfectly suits your requirements. Some of the crediting methods used by the insurance companies include the following:
- Annual Point to Point Averaging
- Biennial Point to Point Averaging
- Monthly Point to Point Averaging
- Daily Averaging / Monthly Averaging
- Hindsight Index Strategy Monthly Averaging
Annual Point to Point Averaging
Annual point-to-point averaging method is calculated by taking the difference of opening and closing index value during a specific year. The difference between the two is then divided by the opening index value. This gives the percentage of index change. This rate can either be positive or negative.
The insurance companies will then set an index cap rate, floor, participation rate, or a combination of all of them. Index cap rate is the upper limit of the indexed linked interest rate; floor is the lower limit, while the participation rate determines the amount that is actually credited to the account.
How it is calculated: Suppose, the calculated change in the index (Opening – Closing/Opening) is 9% in a given year, and the insurance company sets the index cap rate, floor and participation rate at 8%, 2% and 70% respectively. The amount credited to your FIA account using this credited method will be 5.6% (8% * 70%). Although the index gave 9% returns, the index cap is 8% and the participation rate is 70%, so you would in effect get 5.6% return. In case the index goes below 2% in a given year, your credit amount will be 1.4% (2%*70%). This is the minimum guaranteed rate that you will get on the FIA regardless of the fact that the linked index performed below this rate.
Biennial Point to Point Averaging method is similar to the above method with one distinction that the starting and ending balance difference is taken over two years instead of a one-year duration.
Monthly Point to Point Averaging method is also similar to the above method with starting and ending balance difference taken monthly instead of one-year duration.
Daily Averaging / Monthly Averaging
Daily and monthly averaging methods are beneficial when the markets are volatile. It smoothes out market highs and lows because interest credits are related to the average daily performance of the linked market indexes.
Daily averaging crediting method is calculated by dividing the sum of index values by the number of index values during a given year. Then the opening index value is subtracted from this amount. The resulting percentage is then subjected to index cap, floor, and participation rate similar to the point-to-point averaging method.
Hindsight Index Strategy Monthly Averaging
Hindsight index strategy monthly averaging method is slightly different than the above two methods. The average percentage rate is calculated in a similar fashion to the above method. However, the value that is selected as the interest credit is equal to the sum of:
- Percentage of index change of the best performing index over the term multiplied by 50%, plus
- Percentage of index change of the second best performing index over the term multiplied by 30%, plus
- Percentage of index change of the second best performing index over the term multiplied by 20%
This value is then subjected to index cap rate, floor and participation rate similar to point-to-point and daily averaging methods.
How it is calculated: Suppose, the calculated change in the index A, B, C and D (Opening – Closing/Opening) are 9%, 4%, 3% and 5.82% respectively in a given year.
The highest growth rate is weighted by 50% and amounts to 4.5% (9%*50%), the second highest growth rate is weighted by 30% and amounts to 1.75% (5.82%*30%), the third highest growth rate is weighted by 20% and amounts to 0.8% (4%*20%) while the weights for remaining indices are not calculated at all.
The resulting value is 4.5%+1.75%+0.8%+3%= 10.05%. This value is then subjected index cap rate, floor and participation rate similar to the above crediting methods.
As you can see, there are several crediting methods offered by the companies that sell FIA’s. This article does not cover all of the available crediting methods out there, but the ones that are mentioned have a similar reoccurring theme, and that is that they have parameters or limitations via the cap rates, participation rates and spreads. Getting familiar with these parameters will help you differentiate one FIA from another, as well as help you make an informed decision when deciding how an FIA may fit into your retirement portfolio.
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