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.

But should hypothetical performance be used to select specific indexed annuity contracts? I would argue this is not only inappropriate but actually misleading in most cases. During the life of the contract, one or more of the product’s limiting factors–its cap rate, spread, or participation rate–is usually subject to change. And these limiting factors have a major impact on EPR.

Limits on EPR change because what the carrier is able to credit depends on the movement of the index, the price of the underlying options and, most importantly, interest rates. All of these are variable.

In dealing with these variables, it is good management that truly drives performance. Unless all limiting factors are fixed for the life of the contract, backcasting actually rewards poor management. The problem is, very generous limiting factors are probably not sustainable. Yet hypothetical performance will select overly generous products.

As is the case with mutual funds, the only viable way to identify a well-managed product is actual historical performance. Some index annuities do manage crediting variables under changing market conditions. Let’s look at one of them. Assume that $100,000 put into the product in April 1995 has grown to $198,000 after 10 years. But if the advisor were to backcast that performance over 10 years based on April 2005 crediting variables, the projected ending value would be just $162,000.

What accounts for the difference?

This product’s cap rate–typically the most powerful index annuity EPR limiter–adjusts annually. Cap rates tend to move with interest rates, and the higher the interest rate, the more generous the carrier is able to be. So, since this product’s cap rate was 14% in April 1995, as rates declined, its cap rate declined as well. By April 2005, the cap rate was 9.5%. That’s the cap rate the advisor would use to backcast performance in that month.

How, then, should individual products be selected?

Distributors and producers should use backcasting to understand how various crediting strategies perform with various indices in general. When one or more strategies are chosen, products employing these strategies can be selected.

Historical performance information should be used to choose individual products where available. This will motivate more issuers to make this information public. (For newly introduced products, the track records of other products issued by the same carrier are relevant.)

If historical information is not available, products can be identified using criteria appropriate to choosing any deferred annuity–e.g., the insurer’s financial strength, the investor’s risk tolerance and liquidity needs and so forth.

Given the complexity and diversity of indexed annuity crediting methods, and the general absence of historical data, it’s understandable that so many use hypothetical performance to select indexed annuity products. But it is no more valid to backcast the performance of a particular indexed annuity than it would be to project the performance of a mutual fund based on its current holdings.

Mutual funds buy and sell assets frequently. The important thing is how well these assets are managed. The same is true with regard to indexed annuities. The hope is that one day it will be just as easy to assess index annuity performance as it is mutual fund performance.