Fixed index annuities may have similar labels, but one size does not fit all. It’s what is under the FIA hood that really counts–in particular, the interest crediting strategy. We’ll look at some of the most common strategies here.
A FIA is an unregistered fixed product that relies on a specific index, usually the S&P 500 Index, to provide increased interest earning potential. Those potential earnings are tied to the overall movement of the stated index through interest-crediting strategies, or indexing methods.
The interest crediting strategy selected for an FIA determines several factors, especially those shown in the box. The differences are what set fixed index annuities apart from each other, as will be seen below.
Keep in mind that with the index-linked interest crediting strategies, interest is credited annually at the end of the contract year. Since market shifts can’t be predicted, the amount of interest to be credited at the end of each contract year is unknown. Once interest credits are made, however, they are protected. Neither the initial premium nor any earned interest credited can be diminished by the market or the index.
There are many interest crediting strategies in use today, but here are some of the most popular ones:
Point-to-Point Cap: This strategy provides 100% index participation up to a predefined cap; the cap is typically guaranteed for one year and, in some products, is subject to change annually.
Example: If the cap was set at 6% and the index increases 10%, the point-to-point cap strategy would credit the full 6%. If the index increases by only 3%, this strategy would provide 3%. Typically, if the index decreases over the period–whether by 1%, 2%, or more–the point-to-point cap strategy provides that the FIA holds its beginning value (that is, the account value does not reflect the index loss for the period).
Point-to-Point Participation: This strategy imposes no limit (cap) on the annual interest credit. Instead, it credits a set percentage of any increase that occurs.
Example: Assuming the participation rate is 50%, if the index increases 12% in an annual period, the strategy would result in the FIA being credited with 6%. Or, if the index increases 8%, the point-to-point participation strategy would result in a credit of 4%. However, if the index decreases over the period, the point-to-point participation strategy will provide that the annuity holds its beginning value (not reflect the index loss for the period).
Monthly Average: Unlike the previous 2 strategies, where interest crediting is handled on an annual basis, the monthly average strategy compares the index value at the start of the contract year to an average of 12 index values occurring each month throughout the contract year. As with the participation strategy, there is no predefined cap. There is, however, an annual interest spread or fee.
Example: In 2003, the average of the 12 values in the S&P 500 Index was 967.93. This was 10.01% above the S&P 500 Index at the beginning of the year. Assuming an interest spread of .65%, the policy simply subtracts that spread number from 10.01%, leaving an interest credit of 9.36%.
Similar to the other crediting strategies, the beginning value will be protected and will not reflect index decreases.
Monthly Point-to-Point (a.k.a. Monthly Cap): Like the monthly average strategy (above), the monthly point-to-point strategy uses monthly values as opposed to annual values. However, the difference is that this strategy imposes a cap on each month’s earnings.
Example: Assume a 2% cap during the same 2003 period used for the monthly average strategy example above. The cap is applied to each month’s earnings as determined by the index, with no downside protection. In January 2003, the index fell by -2.74%. This negative return would have been directly applied to the strategy. In April, however, the index was up by +8.10%. With the cap in place, 2% is credited by this strategy. The sum of the strategy’s 12 monthly values is then calculated to produce the total return. In this instance, the strategy produces a gain of 8.45% in 2003. In instances where a total return is negative, a limit is placed at zero.
What’s the message here? Check under the hood to ensure selection of the right product.
Each method, while sharing some similarities, is unique and requires a little “kicking of the tires” before hopping in. Not every strategy is suitable, or desirable, for all market conditions.
If the index was up 10% year over year for 5 years, the point-to-point cap strategy would yield no more than 6% per year using the hypothetical stated earlier. In this same example, the point-to-point participation strategy would have increased 5% per year. Conversely, in a more moderate market, the reverse would be true. If the index was up 4%, the cap strategy would credit the full 4%, whereas the participation strategy would gain 2% or whatever the minimum guarantee may be.
Depending on the annuity carrier, investors have the ability to re-elect strategies on a set basis, usually annually. So while fixed index annuities aren’t available in various shades of red or blue like cars, they are built for the long haul and the road ahead. Many financial professionals and their clients can select an interest crediting strategy that fits their preferences.