There are several different kinds of index annuities, but the “Annual Reset” type is the most commonly sold (and bought). The name refers to the interest crediting period – the length of time over which gains and losses in the equity index (often, but not always, the S&P500®) will be measured and index-linked interest will be calculated and credited. There are different types of annual reset annuities. Some measure monthly index movements, from which they calculate and credit interest annually (the “Monthly Sum” or “Monthly Average” types). By contrast, the “Annual Point to Point” measures index movement using only two index values – the Beginning Value (as of the annuity issue or anniversary date) and the Ending Value (one year later) – which is why it’s called the “Annual Point to Point” (APP) method. This type of index annuity is the easiest to understand, and it’s what we’ll be examining in this article. But it’s important that we understand that all “annual reset” types credit interest annually and “reset” the index starting value (from which index-linked interest will be calculated) at the end of each contract year.
How does “Annual Reset” work in an “Annual Point to Point” index annuity?
On the issue date of the annuity, the value of the index (we’ll use the S&P500®, as it’s the most commonly chosen index) is recorded. One year later, on the policy anniversary, the index value is again recorded and the difference between the two values, as a percentage of the beginning value, is calculated. If the index showed a loss (the ending value was less than the beginning value), the contract is credited with zero percent interest. Index losses in an Annual Point to Point annuity are treated as zero percent gain. If the ending index value was higher than the beginning value (i.e.: the index showed a gain), that percentage gain is credited to the contract after adjustment for Participation Rate and Cap Rate.
The “Participation Rate” is the percentage of index gain that will be recognized for purposes of index-linked interest crediting. There is a very common misconception that if the participation rate is less than 100%, the insurance company “keeps” the difference. This is a myth. Issuers of index annuities buy bonds to back the contractual guarantees, and this typically takes most of the premium. After paying for the bonds, expenses, and the company’s required profit margin, the remaining premium is typically invested in call options on the index (which pay off if the index gains value). Usually, there is not enough left to buy options on 100% of future index gain. If the insurer can buy options on only a fraction of that gain, it can credit interest on the annuity only on that fraction. If there is no gain in the index or if the index value declines, the call options expire worthless and the insurer credits the annuity with zero percent interest.
The “Cap Rate” is an upper limit on the amount of interest that will be credited. Insurers impose this limit to limit their risk exposure and because the call options they purchase often have their own cap rates. Often, an index annuity imposes both a participation rate and a cap rate. When this is the case, the index crediting works like this:
The S&P500 index value grew by 11% over the contract year.
If the participation rate is 60%, the resulting index value is 60% of 11% – 6.6%. If the cap rate is 5%, the annuity will be credited with 5%. In other words, the annuity will be credited with 60% of the index gain, but not more than 5%. If the index declined, the annuity will be credited with 0% interest.
One of the big attractions of an Annual Point to Point annuity – or any index annuity that uses “annual reset” – is what happens after the index has declined. In such a “down year”, the index annuity loses no money; its value at the end of the year is the same as at the beginning. But the next year’s “baseline” (from which index gains will be calculated) is reset to the index value after the loss. Any “rebound” in the index will result in index-linked interest even if the index value does not recover the previous year’s loss.
Here’s a graphic example:
If the index in the first year declines by 20%, the index annuity value remains unchanged. When the index “rebounds” by 12% (half of the previous year’s loss), the index value is still less than at the beginning of the first year, but the annuity will be credited with interest based on a gain of 12.5%. At a 60% participation rate, the interest credited will be the higher of 7.5% (60% of 12.5%) or the cap rate.
Here’s an example of an Annual Point to Point index annuity with a 60% participation rate and a 5% cap rate:
The S&P500® value, without dividends, from the beginning of 2000 through 2009 is reflected in the blue line. The value with dividends is shown as the green line. In both, the extreme market volatility in that period resulted in a loss after ten years. But the index annuity(the red line) earned over 26% in that period. While it did not participate in more than 60% of the index gains, it participated in none of the annual losses.
Here’s another look at that same annuity, with the same index performance:
The brown rectangles represent index growth or loss. The blue rectangles show index-linked interest credited to the annuity. In this scenario (actual historical performance of the S&P500®, with and without dividends, from 2000 through 2009, an index annuity with a 60% participation rate and a 5% interest rate cap), the annuity actually outperformed the underlying index. This is not a result anyone should count on. In most historical situations, an index annuity will underperform the underlying index, often significantly. An index annuity is a fixed annuity, offering the same guarantees of principal and minimum rate of interest (although some contracts offer a minimum interest rate guarantee barely greater than zero), and is not an alternative to investing in equities.
The historical situation shown in the graph is unlikely to be repeated often, but it was chosen to demonstrate that even when an “annual reset” index annuity offers low participation rates and cap rates, it can perform well, compared with “safe money” alternatives – especially in a highly volatile market environment.
Disclosure: Some of the material in this article was taken from “Index Annuities: A Suitable Approach” by Jack Marrion and John Olsen (Olsen & Marrion, LLC, 2010 – available at www.indexannuitybook.com).
About the Author: John L. Olsen, CLU, ChFC, AEP is an insurance agent and estate planner practicing in St. Louis County, Missouri. With over 40 years experience in the financial services industry, he serves on the boards of the St. Louis Estate Planning Council and the St. Louis chapter of the Society of Financial Service Professionals and is a Past President of the St. Louis chapter of NAIFA.
In addition to serving his own clients, John provides case consulting services to attorneys, accountants, insurance agents, and financial advisors, and provides expert witness services in litigation involving annuities and investment products. Contact John at (314) 909-8818 or firstname.lastname@example.org to receive personalized professional guidance in addressing your retirement needs.
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