With equity index annuity sales surging, products proliferating, confusion reigning and regulators lurking, this may be the time for the industry to develop a common language to talk about index interest crediting.
Articles have been written and sales presentations developed by well-meaning folks giving lots of pearls of wisdom such as: “Only buy 100% participation products” or “Avoid spreads” or “Averaging is bad (or good)” or “This offers 36% first-year potential return.” Everyone seems to have an opinion on the good and bad. Often, misperceptions multiply and eventually become conventional wisdom.
What often seems missing from the discussion is the index annuity’s effective participation (EP)–the actual portion of index growth as a percentage of total index growth between 2 points in time. EP is a look-back measure, but it can yield clues as to a product’s realistic potential return.
Consider a product that claims 100% participation and imposes a cap; this product simply will not achieve 100% participation in all market scenarios. Likewise, if a product offers 100% participation on some sort of averaging basis, true full participation will still not be achieved. By contrast, an EP assessment will help the advisor demonstrate a more likely participation result over time. That will help both advisor and client make a more informed decision.
Example: Take an equity index annuity purchased on Jan 1, 2003. In the following 12 months, a direct investment in the S&P index would have returned 26.4%. Table 1 shows what the EPs of various equity indexed product designs would be.
These results present a quite different and more realistic story about how indexed products perform, and they provide a common comparative measure for discussion. Most importantly, they create a common denominator instead of reliance on the product’s often confusing and misleading crediting terminology.
Does this mean that any one method was necessarily better than another? Not at all. Different markets produce different results for various designs, but one design rarely works well in all types of markets.
Now, let’s add 2004 into the mix. Here the S&P returned 8.99% from Jan. 1 to Dec. 31 for a total of 37.75% over the 2 years, 2003 and 2004. Table 2 shows the EPs for various designs over the 2 years.
Again, the main point of the examples is not that one design is better or whether the examples reflect actual rates, but rather how using EP provides a more realistic retrospective picture of potential. Over the longer term, some products take advantage of annual reset capability, a feature that can bring the overall participation rate higher by eliminating negative years completely.
Why then, is there a continued push to inflate the prospects for ultimate crediting in index annuities? Carriers seem to be in a race to the bottom to see who can come up with clever ways to deflect the conversation away from the fact that full market participation is not possible. Is that a bad thing? No, the focus for selling these products has been, and always should be to:
o Link interest crediting to market growth, allowing a reasonable chance to outperform similar fixed vehicles.
o Eliminate negative years and their bad compounding effects.
o In many cases, the product’s annual reset capability captures the recovering years of down markets.
o Offer minimum surrender value guarantees.
o Inability to replicate any of these features by direct market investment.
So, what can the advisor and client do when confronting a barrage of confusing crediting features and product claims? Look for products with index choices that are different and complement each other.
Then try to blend the client’s index allocations among the different account options in order to take advantage of different types of markets. This alleviates any guessing on what the market will bring, as the whole point of equity indexed annuities is to put a foot in the water of market growth while keeping money safe and not subject to speculating.
Crediting designs will tend to fall within a similar range of true participation over the long haul so don’t be swayed by claims of unattainable levels. Start comparing the historic effective participation of products when hearing a pitch on the “next big thing.”
Educate clients on the real expectations of these products and, as always, never compare the products to investments and direct market participation. Index annuities have many unique features, all of which protect a client’s safe money. Focus on these and start talking reasonably about index crediting.
John G. Bonvouloir, CLU, is vice president-product management with Aviva Life Insurance Company, North Quincy, Mass. His e-mail address is firstname.lastname@example.org.
Using the effective participation measure provides a more realistic picture of true potential