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Getting the same spin of the wheel on index annuities

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If index annuities using annual point-to-point, monthly average, or cap forward crediting methods each paid 4 cents out of a dollar of premium to buy index-linked gain potential on that dollar of premium, the “gain-payer” guaranteeing to pay any index-linked gain would want to make sure that the probability of a payout was equal for all methods. Or else everyone would flock to the crediting method with the best odds and the gain-payer would lose over time.

The index annuity gain-payer, who is usually the seller of the options covering the hedge, uses past index performance history and a guesstimation of how other factors like yields on alternative investments, volatility and such will affect the index movement, and then says what potential upside will be offered on the 4 cents received. In the same way you use a roulette analogy, the gain payer’s task is to try to ensure that everyone gets the same “spin of the wheel” for their 4 cents.

What this means is that one annuity on a given day might offer, say, 100 percent of the point-to-point gain up to a 7 percent cap, while another offered 80 percent of the monthly average gain. And still another used a 2.5 percent monthly cap forward-not loss structure to measure performance, because the gain payer believes that these crediting methods, at these rates, have the same odds in producing the same return.

Does this mean that different methods perform the same each year? No. Different methods react differently to different markets. In 1998, averaging methods produced the highest index annuity interest, while in 1999, annual point-to-point with cap structures best rewarded their annuity owners. What the gain payer is betting on is that if his analysis, for example, showed that an 80 percent monthly averaging rate and an annual point-to-point with 7 percent cap produced the same returns over the long haul in the past, this will hold true for the future. The roulette wheel might come up showing “16″ four times in a row, but over time the other numbers will come up and it will all even out.

Does this mean all index annuities will perform the same over time? No. Different products have different pricing structures based on carrier profit goals, product expenses, and length of surrender period. This means one annuity might have 4 cents available from each premium dollar to use for the index-link, another has 3 cents and yet another has 5 cents.

There are even times when you will find some methods that appear to have better performance probabilities than others in the next year. This is due to the gain payer’s guesstimation that some current factor will alter the long-term odds in the short term. But it should be remembered that unlike the casino, the index annuity carrier can change the odds while the wheel is spinning – during the surrender period. Regardless of any temporary advantage today’s pricing may give, the final game is still determined by the carrier on subsequent spins.

Ultimately, it is the carrier that decides how much money is available to fund the index-link. This is why I continue to believe that the most important factor in index annuity returns is not the crediting method, but how the carriers will treat the annuity owner when they reset that cap or rate in the future.