Problems occur if brokers unwittingly create unrealistic expectations in the minds of deferred annuity clients.

An example would be unintentionally giving just enough information to allow the client to draw conclusions about future product performance–conclusions that aren’t realistic because they are based on an incomplete understanding of the facts.

Index annuities provide a great example. Let’s start with a quick poll question:

Will a renewal index rate cap on an annual, point-to-point index annuity likely go up when the index has been gaining over the last few months?

If you answered no, you’d be correct. The fact that the index went up during the contract year (and is higher now than it was on the prior policy anniversary) is not relevant to setting the renewal rate cap.

In a sales situation, however, problems can occur if the broker creates an expectation in the client that the renewal rate cap is directly linked to the index performance. This is an unrealistic expectation. It’s quite possible the renewal rate cap will go down even when the index is going up. On the flip side, the client may be happy to know the same holds true when the index is going down–it’s quite possible in that scenario that the renewal rate cap could go up.

To keep client expectations reasonable at renewal time, it’s important to know how the renewal index rate cap is set each year. The reality is that renewal rate caps on annual, point-to-point index annuities are set basically the same way initial rate caps are set. For example, in today’s low interest rate environment, an insurer would invest about 96% of the original deposit in bonds and mortgages. The blended return on those investments is what supports the minimum guarantee on the annuity. With the minimum guarantee secured, the remaining 4% is used to purchase 1-year options that allow the company to credit excess interest to the account if the index goes up in value during the index term.

Because the only amount that can be spent to purchase the option is 4% of original premium, the price of the options determines how high the rate cap can be set. At the end of the investment year, the options expire, or are cashed in if they are “in the money,” and new options are purchased to hedge the index movement for the upcoming index term.

Since the cost to purchase options changes on a daily basis, the client should expect renewal rate caps to change, to some degree, every year.

Option costs that support index growth annuities are determined in large part by the volatility (up and down movement) of the index used in the contract (the most common index is the S&P 500). So, the fact that the index is up over a certain period is not a primary factor in determining the option cost; volatility is the key.

Typically, annuity providers receive quotes for the options from multiple Wall Street providers. Once a company prices options, it combines that information with the return it receives on the underlying investments (the bonds and mortgages) and sets the index rate cap.

Therefore, the most influential factor in determining the renewal rate cap on an indexed annuity is the cost of the options bought to hedge the risk of paying excess interest if the index goes up.

While these costs are the key driver, renewal rate caps are also sensitive to changes in interest rates–just like fixed-interest annuities. Actually, renewal rate caps on fixed index annuities are much more sensitive to interest rate changes than are rates for traditional fixed annuities.

For example, if a carrier needs to adjust crediting rates on a traditional, fixed-rate annuity because the underlying portfolio has drifted 10 basis points up or down, the carrier will simply adjust the renewal crediting rates by exactly 10 basis points. However, with an index-rate annuity, an adjustment of 10 basis points due to interest rate movement will result in a 20-25 basis point change in the rate cap.

So, if one is accustomed to seeing small adjustments for interest fluctuations on renewals of multi-year guarantee annuities (MYGAs), expect those same adjustments to occur with renewal rate caps in an amount that is at least twice those of MYGA rates.

A number of factors make this process somewhat less than exact science. For instance, timing of renewal rate cap announcements may not coincide perfectly with the purchase of options to support the renewal rate cap. Also, if the contract has multiple fund options, the movement of money between the funds influences the notional amount of options a company must purchase to support its liabilities.

That said, it’s important for the broker to understand there will be movement in renewal rate caps. The better the broker prepares a client for this reality, the less painful the discussion will be at renewal time. In most cases, success is all about knowing the product well enough to set reasonable expectations with the client.

Well-designed indexed contracts should stay on the books until the policy owner needs the money for retirement or succession planning. If performance is linked directly to performance of the S&P 500 or other reliable index, and if rate caps (initial and renewal) are competitive, there should be no reason for the business to move. Some insurers have also added bail-out provisions that protect the owner from reductions in renewal rate caps not favorable to the consumer. This all adds up to a safe and reliable long-term package.

The message: Understand how the contract and the investments backing the contract work together and look for companies that publish renewal rate caps every month and provide a bailout option without surrender charges. This will help brokers manage client expectations, avoid difficult discussions at renewal time, and help grow the business successfully.

James E. Teague, JD, CLU, is vice president-individual annuities at Standard Insurance Company, Portland, Ore.