Indexed annuities have become an established member of most financial advisors’ repertoire in recent years, gaining in popularity as clients seek out low-risk ways to participate in rebounding equity markets. Despite this, several years of relatively stable market performance has reduced the appeal of these products, which typically cap the client’s ability to realize the full extent of any gains.
Because of this, carriers have developed new twists on the uncapped index crediting method in order to allow for greater market participation while also tailoring volatility in the underlying equities. While these uncapped crediting strategies may be an attractive option to some clients, others may be in for an unpleasant surprise down the road—making it important that they understand the fine print before jumping in.
Innovations in Index Crediting
Index crediting is essentially the way that market gains are credited to a client’s indexed annuity value—the annuity itself is tied to a market index (or indexes), the performance of which governs the performance of the annuity. Many indexed annuities are subject to a cap in order to reduce the insurance carrier’s risk—for example, if the market gains 10% and the product cap is 5%, the client’s account will be credited with a 5% gain (absent other product features).
Uncapped crediting removes the cap. Recently, carriers have begun experimenting with a tailored approach to the underlying securities that govern the annuity’s performance. Some have begun combining this tailored basket of equities with an uncapped index crediting strategy in order to maximize the indexed annuity’s performance.
Using this strategy, the carrier will adjust the annuity’s exposure to the underlying mix of securities in order to reach a stable target volatility level—often on a daily basis to ensure consistency. Interest is credited using a traditional crediting method (i.e., the beginning index value is compared to the ending value, and the difference provides the basis for the amount credited), though some carriers credit these accounts less frequently than is typically the case (every two years rather than monthly or annually).
Theoretically, because the underlying basket of equities is chosen in order to reduce the risk of large swings in value, the consistent performance over a longer period of time should lead to larger interest values being credited to the client’s account.
The Fine Print
As most advisors are well aware, uncapped does not mean unlimited. While indexed annuity carriers that offer an uncapped crediting strategy do not impose a hard cap on the client’s participation in market gains, contracts providing for uncapped crediting continue to limit the client’s participation using participation rates, spreads and fees.
Many products that offer uncapped crediting may combine a participation rate with a spread in order to reduce the potential for realizing gains. A participation rate essentially limits the percentage of the annuity that is participating in increases in the underlying portfolio of assets. A spread deducts a set percentage from the value of any increases before crediting the account (i.e., a 10% gain combined with a 5% spread leads to a 5% credit, absent other limiting features).
Clients also should be aware that uncapped products may simply be more expensive than other available products—fees and commissions can reduce the value of the stable interest crediting to the client in the long run, and should be factored into the client’s cost-benefit analysis.
Uncapped index crediting strategies can appeal to many clients—removing the hard cap on market participation can allow for greater returns, provided that the client has carefully examined the terms of the indexed annuity product in order to fully understand any additional limitations that could effectively serve to place a cap on gains.
For more on index crediting, see Maximizing Fixed Indexed Annuity Earnings With Interest Crediting by Messrs. Bloink and Byrnes.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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