Perhaps the most common question asked by advisors who are considering index annuities for their clients is, “which kind is best?” In our opinion, the only reasonable answer is, “it depends.” Any crediting method can produce the best return for a given period. There are, however, certain general observations that one can make regarding index annuity policy designs.
1. Annual reset
Like a fixed rate annuity — a conventional fixed annuity — the annual reset, or annual ratchet method, credits interest each year. The amount of interest credited each year is based on the movement of the underlying index during that year, calculated from the ending balance of the index for the previous year. An essential characteristic of annual reset index annuities is that losses are ignored. If the index movement in any year is negative, the contract treats that loss as a zero percent gain and credits zero interest for that year. Another essential characteristic is that, because gain is measured from the index value at the end of the previous year, an annual reset IA can credit interest based on index gain even if the index value, after that gain, is less than it was at some earlier point in the contract.
With an annual reset index annuity, the purchaser knows how much her annuity is worth at the end of each year. Interest is calculated, credited and locked-in each year. Future decreases in the index will not reduce the annuity value. The biggest trade-off to this is that the participation rate, cap rate, or yield spread is likely to be lower than in other designs. These contracts generally excel in markets with high volatility, although such volatility tends to increase option costs and reduce participation rate or increase yield spread.
The point-to-point, or term end point, design measures index movements over a period greater than one or two years and does not calculate or credit interest each year. The investor’s return is not known, and cannot be estimated, until the end of the term period, which is typically seven to ten years. The index gain is calculated by dividing the index value at the end of the term by its value at the beginning and then subtracting 1. For example, if the index is 100 at the outset of the contract, and ten years later is 180, the index gain is 80% [(180 ÷ 100) – 1]. That gain is then adjusted by applying any participation rate and the resulting interest percentage is multiplied by the initial contract value to produce the interest to be credited. For example, at a 70% participation rate, the cumulative interest credited would be 56% (80% x 70%). Such an annuity, purchased for $100,000, would be worth $156,000 at the end of the 10 years.
The point-to-point design does not allow the purchaser to know the value of the annuity until the end of the term. However, the rates for the moving parts are likely to be greater than for other policy designs with the same term. In addition, because many or all of the bonds and call options are put in place when the contract is acquired, point-to-point contracts tend to have fewer moving parts that may be changed after the contract is initially acquired.