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Capped vs. Uncapped Indexed Annuity Strategies

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What You Need to Know

  • Justin Jacquinot says cap rates are popular because they're easy for customers to understand.
  • The cap rate for an index with built-in volatility control features might be higher than the cap rate for the plain S&P 500 index.
  • The lower the cost of the options used in hedging are, the higher the cap rate can be.

Some financial professionals may eat, drink and breathe annuity contract provisions. They know everything about every annuity contract feature since the Egyptians developed hieroglyphics.

Some other people in and around the world of annuities, such as new agents, or people in support services roles, may just be trying to keep their heads down and not get into trouble.

Justin Jacquinot, a senior vice president for direct relationships at Security Benefit, a Topeka, Kansas-based annuity, helped out by answering a series of questions about one common annuity feature — indexed annuity strategy caps — through an email interview.

The purchasers of an indexed annuity can tie a portion of the crediting rate, or all of the crediting rate, to one or more indexes in the contract’s index menu. A cap is a limit on the interest rate the issuer will pay in connection with an index strategy.

A cap may irk an annuity holder during a year when investment markets soar higher, but it may help the issuer structure the contract in a way that will make the math work over the entire life of the contract, which may include bad years and so-so years along with great years.

Here’s what Jacquinot said about indexed annuity rate caps:

1. How often are capped strategies really used in indexed annuity products, at Security Benefit and in the market as a whole, in terms of what the insurers offer and what the customers actually buy?

The usage of capped strategies varies by consumer, and by product, due to a variety of factors including the crediting strategies that are available.

At Security Benefit, our FIA [fixed indexed annuity] products generally offer several crediting strategies to choose from, and we see a lot of diversification across strategies.

For example, our Strategic Growth products offer 14 crediting strategies, and with this type of product series we typically see lower allocation toward our capped strategy, but it still is a significant allocation.

2. What kinds of subtle (and not-so-subtle) variations in cap rates do you see out there that clients, especially, might not have noticed?

A capped strategy is popular because it is offered widely in the industry.

For example, the annual cap of the S&P 500 index is part of the simplicity of the design. It is easy for a consumer to grasp the concept and track the product themselves throughout the year.

Strategies like this are pretty universal in design throughout the industry, which makes it easy for consumers to compare cap rates for that particular strategy across other products.

Cap rates are just one feature of a product; however, a variety of other features/rates should be taken into consideration as well.

The underlying index that a capped strategy is using can also impact the level of the cap rate.

For example, an index that has some form of volatility control built into the index may have a higher cap rate than the cap rate on the S&P 500 index.

3. How do the cap rates fit in with the derivatives or other hedging arrangements insurers use? Are the cap rates just an adjusted version of what’s in the hedging arrangement contracts?

For FIA products, we have a hedge budget that is set aside to purchase options for the crediting strategies. The hedge budget itself can be affected by many different functions including investment yield, policy reserves, administrative costs, interest rates, as well as other factors.

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The second piece of the puzzle is the option costs. For a particular crediting strategy and the hedge budget available, more expensive option costs would result in a lower cap.

Conversely, if option costs were to decrease, assuming the same hedge budget is available, would result in a higher cap.

4. How do ups and downs in cap strategies affect cap provision offerings and customer take-up rates?

Generally, higher caps will attract more allocations to that strategy, similar to how higher interest rates on a fixed annuity will often lead to an increase in sales.

5. How do ups and downs in the stock market and other investment markets affect cap provisions?

There are a variety of factors that can influence a cap rate, including index volatility, option costs, interest rates and investment earned rates. Ups and downs in the stock market typically introduce higher volatility expectations for an index.

However, for options hedging capped strategies, index volatility has a muted impact on the cost of the options due to how a cap is priced in the market.

6. How hard or easy is it to offer capped and uncapped strategies in the same product? How do you handle it when too many people choose one type of strategy over the other?

From our standpoint, it is not overly difficult to offer capped and uncapped strategies within the same product. It takes a higher level of detail and attention when initially building the product and requires extra administrative maintenance and an ongoing review of rates.

However, we feel the extra investment of time is more than worth it in order to deliver a comprehensive FIA product to our customers that gives them the ability to choose to allocate among crediting strategies that may offer capped choices, uncapped choices with a participation rate, or uncapped choices with a spread.

Each strategy can perform better in different environments, and we feel it is important to provide our customers with the flexibility that will allow them to diversify between multiple strategic constructs within one product.

7. Many economists say no one can make useful predictions about what investment markets will do. In that context, does offering people a choice between uncapped and capped strategies really make sense?

We can never be fully certain what future market conditions will hold, but we know from experience that offering clients crediting strategy flexibility, allowing them to diversify between multiple strategies within a product is beneficial, especially when the market fluctuates.

Working with an experienced financial advisor that can help assist clients in managing their portfolio through various market cycles, as well as the various different financial stages of their lives, is critical to successfully navigating the appropriate strategies.

8. Do you find that customers and clients of different types of annuity professionals have different kinds of capped/uncapped preferences?

We have noticed some different trends in crediting strategy allocations across different distribution channels but several similarities as well.

In our book of business, for example, we have seen a higher allocation to capped strategies in our bank channel than in our IMO [independent marketing organization] channel.

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