Crediting Interest With An Annual Reset One-Year Term Point-To-Point Crediting Method
We start with considering how interest is credited to fixed index annuities, since this is the area that differs the most from variable annuities. Since FIAs are fixed annuities, crediting interest is the technical term for the returns generated by the contract value. As with variable annuities, it can be difficult to provide a standard explanation for how these returns are calculated on FIAs. Almost countless methods are used in practice and there is a trend to increase the complexity of the methods used. The discussion here cannot be comprehensive, but I will try to provide enough of a general understanding of the main options found in practice.
FIAs will generally provide options to either credit interest at a fixed rate, or as based on the performance of an external index. The amount of interest received depends on both the index and the crediting method chosen.
Perhaps the most common FIA design is to credit interest through one-year point-to-point crediting with a cap and an annual reset. At the end of each yearly term on the anniversary date of the contract, the interest-crediting formula uses the index gain for that year (the price return for the index over the one-year term) to credit interest. A floor of 0 percent is protected, and full participation is provided for upside gains up to a cap rate. The cap rate can be changed, subject to a minimum allowed value, and is redetermined in advance of each new annual term starting on contract anniversary dates. This is a necessary feature to account for the market conditions surrounding the ongoing costs for creating the FIA protections.
Digging deeper, we must consider the index used with the FIA. Insurance companies generally offer access to different index options as well as a fixed interest option. Contract owners can often combine these options in any way they choose and can change the allocations at the start of each new term. Common index choices include the S&P 500 for large capitalization US stocks, or the MSCI EAFE index that provides representation for international stocks. Companies may also offer other index options seeking lower volatility, such as an effort to pick a subset of less volatile stocks from the wider S&P 500. Lower volatility can help to support better parameters that link returns to the interest credited. Increasing complexity may also be found with dynamic allocation options that will vary the allocations based on predetermined formulas which adjust to volatility. To keep this discussion manageable, I will describe the S&P 500 as the index of choice for an index-linked FIA. It is a commonly used index in practice and matches the general assumption throughout much of this book that the stock market is represented by large capitalization US stocks.
Another important matter must be addressed regarding the index. As mentioned, annuity premium dollars are not actually invested in the underlying index. Rather, the insurance company is purchasing financial derivatives that provide a return based on the index performance (more on this shortly). An implication of this process is that interest-crediting is not based on the total returns from the underlying index. Dividends are generally excluded from the calculations. Only the price returns (capital gains or capital losses) play a roll. This is an important detail because, historically, dividends have been an important part of the total return for the S&P 500.
For the Morningstar data on S&P 500 returns from 1926 through 2018, the compounded growth rate for the S&P 500 was 10 percent. However, with dividends excluded, the price returns were only 5.8 percent. It is the latter number that matters for determining FIA interest.
The dividend issue requires extra caution because there is a tendency to confuse this point in the marketing literature for some fixed index annuities. As will be discussed, FIAs should be considered as a potential alternative to other fixed-income assets, but some marketing literature emphasizes that an FIA can beat its corresponding stock index, suggesting higher returns with less risk. The comparison may be in terms of the cumulative growth for FIA assets relative to the S&P 500 from some starting date, with the idea being that the FIA provides a greater wealth accumulation at the end. While it is possible for an FIA to outperform its linked stock index occasionally, especially if the time period included significant market downturns that let the FIA shine, this should not be expected as a typical outcome.
The problem is that marketing comparisons are made in terms of comparing the FIA returns against the price returns of the S&P 500 with dividends excluded. That comparison might be justified since the FIA performance is based on the price returns. But I find it misleading because if an individual were comparing an FIA with a corresponding stock index mutual fund or ETF, the corresponding fund would provide total returns including dividends. It will be more difficult for an FIA to beat the total return performance of the corresponding index than to just beat the price returns.
I have found that the compliance departments of insurance companies are usually quite strict and take great care to properly disclose matters and to avoid misleading consumers. And while such marketing literature does provide small-print disclosures that the price index is being used instead of a total returns index for the investment alternative, I can only imagine that the vast majority of individuals reading the marketing piece would overlook, or not otherwise understand, this vital detail. It may lead individuals to believe that FIAs can reliably outperform the stock market without accepting the downside risk of the stock market.
Again, the joint combination of downside protection along with a portion of upside may occasionally be adequate to outperform the associated index, but FIA owners should not expect this to happen regularly, as it would defy the financial maxim that there is no such thing as a free lunch in terms of earning higher returns without taking on greater risks.
As for credited returns, FIAs provide downside protections with limited upside potential as based on the performance of the linked index. For instance, having a floor of 0 percent on credited interest ensures that if the index experiences a loss during the contract term, the contract value of the FIA is protected from loss. Even bond funds have downside risk for capital losses when interest rates rise. FIAs are usually structured to avoid such losses. Because there is a cost for creating protection for the contract value against a loss when the index declines in value, one should not expect to receive the full upside potential from the index. FIAs do not provide a way to get the returns from the stock market without accepting the risk of the stock market.
Looking for more information? Click here and subscribe to the Retirement Researcher for my weekly newsletter and receive additional articles, resources, and exclusive invitations to upcoming webinars!
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon AMZN .