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December 04, 2005 at 02:00 PM
Index annuity product selection is difficult for both producers and distributors because of challenges in comparing their probable future performance.
Of course, no one can predict with certainty the future movement of the underlying index. But selecting any investment involves this uncertainty.
One might prefer one index over another based on expected future movement. But the real goal is to assess the probable performance of the crediting strategy.
Index annuity crediting methods are quite diverse and tend to be very complex. So, the first challenge is how to compare them. The answer is rather simple in theory. Since the index itself will fluctuate, we want to see the effective participation rate (EPR). This tells how much index increase would be credited as interest.
Example: If a contract credited 11% and the underlying index rose 14% over the last 12 months, the EPR would be 79% (11 divided by 14). In a rising market, the EPR will usually be less than 100% because one or more of the following limits index gains: cap rates (maximum percentage credited), spreads (portion of the return retained by the issuer), or participation rates (percentage of the increase credited). (Depending on how the contract measures movement of the index, the EPR and contractual participation rate may differ.) One would also want to take guaranteed minimums into account because these prevent losses when the index declines.
The EPRs of various crediting strategies will vary with the direction of the index and its volatility, so it makes sense to determine how these methods perform under different market conditions.
“Backcasting” is the most popular approach for assessing crediting method performance in index annuities. It is the easiest to understand, too. It applies the method of measuring index movement (annual or monthly point-to-point, annual reset, etc.) and the limiters of gain and loss to actual index movement in various historical periods. It is important to look at several periods, not just the most recent one, since other periods had gains or losses of greater magnitude or duration.
By contrast, Monte Carlo simulation can assess how the crediting methodology performs by applying it to a series of randomly generated index movements and providing probable rates of return.
Either approach–backcasting or Monte Carlo–will demonstrate that there is no single best indexed annuity crediting strategy.
For example, the “monthly averaging” methodology tends to outperform other methodologies during periods of index volatility at the expense of lower EPRs when it rises consistently.
In developing recommendations for an investor, crediting strategies should be selected based on expectations of index movement and the investor’s risk tolerance.
Distributors’ product lines should include contracts with various underlying indices and methodologies that perform best in different market conditions.
