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.
3. High water mark
In this variation on the point-to-point design, index-linked interest, if any, is credited based on the difference between the starting index value and the highest value of the index — usually, at policy anniversaries — during the period. This method is rarely used in currently issued contracts because the cost of the options is higher, and so index participation would have to be much lower than for other interest crediting types.
The high water mark design protects the annuity owner from a decline in the index at the end of the term, which could wipe out much, or even all, of the gain previously experienced, but not credited. However, the rates for the various moving parts are likely to be less attractive than for a contract with a point-to-point design with the same term.
4. Guaranteed living benefit riders
Given the enormous popularity of Guaranteed Living Benefit riders in variable deferred annuity contracts, it was just a matter of time before issuers of fixed annuities — including index annuities — got into the game. In 2006, the first Guaranteed Lifetime Withdrawal Benefit was offered as a rider on an index annuity. By the end of that year, seven index annuity carriers were offering GLWBs, with more carriers considering the addition of these benefits.[i] As of December 2011, GLWB riders are offered in many index annuities and are very popular. As to other living benefits in index annuities, no index annuity, to our knowledge, offers any of the other two basic types of guaranteed living benefits (GMIB or GMWB).
In our opinion, though, neither of those benefits really makes much sense in a fixed annuity — and an index annuity is a fixed annuity — because both are designed to offset the loss of a significant decline in the annuity’s cash value. Conventional fixed annuities are never susceptible to this loss; neither are index annuities of the annual reset or high water mark types. A Final End Point-type index annuity might be, except that most contracts of this type employ averaging, which provides considerable protection against significant end-of-term declines.
[i]. Jack Marrion, A Look At Annuity And Securities GLWBs (Advantage Compendium, August, 2008, available at www.indexannuity.org).
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