Let’s look into the crediting methods within the Index Annuity, which is where the rubber meets the road for performance. This is where most investors get lost and either have to shop for themselves, or have to rely completely on their agent to find the best products available.
The three most common crediting strategies we see today within Index Annuities, are the Annual Point to Point (AP2P), Monthly Point to Point (MP2P) also known as Monthly Sum, or Monthly Cap, (all the same thing), or the Averaging method. It’s getting complicated already right? Let’s dive in and see how this works so you can see what to look for when purchasing an annuity.
To understand the mechanics of what affects the crediting method in an index annuity it is important to understand that the insurance company purchases a call option on the market index they are offering in the annuity. We are seeing many different indexes available today, but for simplicities sake let’s assume the S&P 500 is being used. They of course cannot purchase 100% of the upside of the index, so different variations of options have been designed to pick up gains. Two things to keep in mind, the more volatile an index, the more expensive the call option is, and the longer the time period of the call option the lower the price of the option.
This is the simplest method to understand. Calculate what the market index does between the starting point and the ending point, which is your anniversary date of the annuity, just like how we measure any investment. Most companies today offer this method with a cap on the gains, because with the money they have available for the option this is all they can get. Many companies today have caps in the 3 to 4% range. So if the S&P does 10% and you have a cap of 4% you get 4%. The company doesn’t get the difference, because that was all the option they purchased could pick up of the upside. Make sense?
Most companies will only provide the option of a cap for the AP2P crediting method. Currently there is some pretty wide variation here in cap rates among companies with the highest caps nearing 6.0% on the S&P 500. (Contact us for the details with respect to product offerings and state availability). So if for example sake, the annuity you are looking at has a cap of 3% and you could get as high as 6%, there is a 3% difference in a good market year, which could make a significant difference in your returns over time. Make sure you are not be sold short here!
There are a few carriers that are offering an uncapped percentage of the AP2P gains, instead of a cap, which is very unique. We are seeing rates as high as 70% of the S&P 500 index, without dividends, and with no cap, with a two year call option. This truly has some upside potential! (Again contact us for product details and state availability.) How important is this? Let’s take 2013 for example, the S&P 500 returned near 30% without dividends and if you capped out at 3% that would be all you would have made, whereas with the uncapped strategy you would have returned nearly 20%. IF you truly want upside potential, which we all do, this strategy is superior to the capped strategy if this is available in your state. Contact us for more information and we can provide you with the details.
Overall, the AP2P is the most consistent and easy to understand crediting method among indexed annuities. There are many exciting new options available in products today in managed volatility indexes, where independent companies will create their own index and manage between equities, bonds, commodities, and cash keeping the volatility level from going too high. Remember earlier one of the major costs of a call option is volatility? By managing volatility the call option can be uncapped and provide incredible upside potential in rising markets and improve overall annualized returns.
How this method works, is instead of looking at the market in a one year cycle, the market is broken down into 12 separate months, and the gains are capped on the upside but not on the downside. All of the months are added together and if it is a positive number, that is your return and if it is a negative number you simply get a zero, you don’t lose anything. Nothing is credited to your account until the term is reached. Most products offer a one year term, although there are some that offer 2 and 3 year terms as well.
So for example if the S&P 500 returns 4% in one month and you have a 2% cap, then so far the crediting method would be up 2%. Now if we had a big selloff and the market dropped 10% in one month then it would take 5 months with gains at 2% or higher to offset this. It’s kind of like a golf scorecard where each hole is figured separately, and the total is added up, so with the monthly cap indexing strategy, each month is figured separately with a monthly cap on the upside.
This method works very well in markets where volatility is low and there aren’t a lot of negative months. 2013 was one of the best years ever for the MP2P method and a lot of contracts returned numbers in the double digit range. Once again there is a wide variation in the rates available today amongst carriers, where some are offering rates as low as 1.0% per month with the highest rates available today in the 2.5% range. In a good market year this can be the difference of 3 to 10% higher returns. This is why it’s important to find the best products out there. Many agents really don’t care about rates and will sell their favorite annuity regardless of how competitive it is. We can show you the highest rates that are available in your state.
This is the least common strategy among index annuities. What we usually see is a daily averaging or monthly averaging strategy. How this works is the crediting method simply takes the index value each day for the daily averaging strategy, adds up all the trading days and divides it by the total number of days. For the monthly average they take the average for each month and add the months up and divide by 12. Both methods are very similar. This value is then compared to the starting value to determine if there are any gains. Of course if it is negative then the client gets a zero return.
What is important with this strategy, is how the market performs over the index period, usually one year. If the market sells off in the first 6 months and then comes up forming a V shaped curve then the average will be lower and the annual returns will be low. Also if the returns are flat in the first 6 months and then increase, the average will still not perform well. In contrast if the market goes up for the first 6 months and comes back down the average will still be positive, even though the market may not have had a positive return at the end of the 12 month period. If you catch a market bottom and the market goes steadily up, the average can do very well.
Most carriers today have a cap on the daily average that is similar to the AP2P cap, so most of the time the AP2P is a better choice. There are a few carriers that actually offer the average strategy with an uncapped version, which in the right market can have very good upside. In fact the highest one year return we have seen in the averaging method was a 39% return, a client actually renewed their contract right at the bottom of the market in March of 2009 and had an uncapped average of the S&P 500 for the next 12 months. This of course does not happen very often, but uncapped averages can bring in very solid returns in rising markets. Again we can show the carriers that offer the uncapped version (if available in your state.)
By the way, most carriers let you change your crediting methods or mix them up on your anniversary date. Knowing which method to use in different market conditions can make a world of difference in your returns.
By now you’re eyes are probably glazing over with all of this information and how do you know what product and crediting method to choose?
This is where working with seasoned professionals that understand the mechanics of the index annuity and are truly interested in providing you with the best possible products can make a huge difference in your returns over time.
DO NOT TAKE THIS LIGHTLY! This is a decision that will affect the next 10 plus years, MAKE SURE YOU HAVE A GOOD ANNUITY! You will have to live with it for years to come and you don’t want to make the wrong choice.
Check out Part 4:
Types of Annuities Part 4: Variable Annuities