Why Are Indexed Annuity Par Rates So High?

What You Need to Know

When interest rates fell, insurers began using volatility control indexes to cut option costs.
Now, interest rates have popped back up and the volatility control indexes are still here.
The result: Insurers have extra cash they can use to increase par rates.

The owner of a fixed index annuity (FIA) can tie its crediting rate to the performance of one or more benchmark or risk control indices.

If an FIA contract has a participation rate, or par rate, over 100%, that means the owner can get a boost to the crediting rate that’s bigger than the percentage increase in the corresponding index.

In recent years, the participation rates, or par rates, for fixed index annuities have risen substantially.

It is no longer uncommon to find par rates over 100%, which is generally a good thing for returns, and that has led to some financial professionals and consumers proclaiming, “It must be magic!”

But it isn’t.

The Problem

The climb of par rates has coincided with the rise in credit yields and here’s why.

During the Global Financial Crisis, the Federal Reserve Board and other central banks lowered interest rates to stimulate the economy. Both bond and credit yields fell accordingly.

This put insurance carriers into a tough spot.

Insurers would typically invest in a range of investment-grade bonds to generate returns. But, when rates fell during the Great Financial Crisis, BBB credit yields averaged approximately 3.6%. Returns on investment portfolios were low.

After insurers deducted business costs, there was not much money left for buying the options needed to offer the crediting strategies used in the FIAs. That, in turn, pushed down par rates.

The Solution

In order to show higher par rates (usually around 100%) under such circumstances, index providers created an innovative solution: volatility control indices.

Lower volatility means lower risk, which translates to cheaper option prices.

For example, the long-term average volatility of the S&P 500 Index is about 15%, but a risk control index typically sets its target volatility at 5%. The lower volatility level means the option on this index would be significantly cheaper than an option on the S&P 500 Index. The price is, very roughly, one-third of the price, on average, although the S&P 500′s swings can at times make it much more than three times more expensive.