While the popularity of fixed indexed annuities (FIAs) has soared in recent years, the decision to purchase the product is only the tip of the iceberg for clients looking to maximize their earnings potential. FIAs have developed to include a variety of features that can appeal to clients with varying goals and risk tolerances—the most important of which is arguably the FIA’s interest crediting method. 

Like annuity products in general, not all interest crediting methods are created equally and the returns generated can vary dramatically from one to the next. Choosing the most appropriate interest crediting method (or combination of methods) for the client can make or break a client’s FIA strategy—and the advisor’s role can prove critical to an informed decision.

FIAs and Interest Crediting

In general, FIAs base the performance of the annuity upon a major index or indices (usually a stock index, such as the S&P 500). Unlike directly investing in the equity markets, the FIA itself generally offers principal protection in exchange for limitations on the potential for investment gains. When purchasing the FIA, the client is able to choose his or her interest crediting method, which essentially determines the way interest is credited to the FIA account value.

The annual point-to-point interest crediting method is a popular option because of its simplicity—the beginning index value is compared to the ending index value on the FIA contract’s (annual) anniversary date, and the%age of change is calculated. If the ending value is higher, the client generally receives interest, and if it is lower, no interest will be credited.

Annual point-to-point crediting can also include a cap or a spread. A cap, as the name suggests, serves to cap the client’s credited interest at the cap amount (i.e., if the index gained 10% and the cap is 6%, 6% will be credited, but if the gain was 1%, the client would receive the 1% credit because it is less than the cap amount).

A spread is subtracted from the value of the gain—so if the index gained 10% and the spread was 5%, the account would be credited with 5% interest.  If the index gained only 1%, no interest would be credited because the spread is greater than the gain.

Monthly averaging can be more complex, because it measures the index value at the end of each month for a year, combines the 12 values and divides by 12 to determine an average. This average is then compared to the initial index value to determine the final value (after which a cap or spread may apply to reduce the amount of interest that will be credited).

Monthly sum is slightly different—using this method requires comparison of the index value on the contract anniversary each month to the prior month’s value and calculating the change.

The increases (or decreases) in index value are combined at the end of the year (and can also be subject to a cap or spread) to determine the interest credited.

Does the Crediting Method Fit?

The monthly sum method is the interest crediting method that is most likely to suffer from market swings—if the index performs poorly for a few months, the amount of interest credited can decrease dramatically.

Annual point-to-point with a spread can also prove problematic because, unlike annual point-to-point with a cap, the interest credited can be reduced to zero even if the%age of change in value is positive (i.e., a 5% gain combined with a 5% spread means that no interest is credited, but a 5% gain combined with a 5% cap credits the client with the entire gain).

Generally, the type of interest crediting chosen will depend upon the client’s tolerance for risk. Building upon the example above, if the index had gained 15%, the client would have been credited 10% after subtracting the spread. If the cap had applied, only a 5% gain would have been realized.

For many clients, the best solution will be combining several of the interest crediting strategies in order to find a balance. In these cases, the client may not be able to fully take advantage of large market gains, but he or she will also be able to generate more consistent returns across the board.

Conclusion

When it comes to choosing the interest crediting method that will apply to a FIA, the possibility of participating in market gains must always be balanced against the risk that no interest will be credited.  The final outcome, of course, will depend upon a careful evaluation of the client’s goals and risk tolerance.

Originally published on Tax Facts Onlinethe premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.    

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