Primary Interest Crediting Strategies

In document Selling Annuities to Seniors (Page 46-50)

Although there are many ways in which interest earned on an annuity can be transferred to the account, there are five primary crediting strategies that are used across the board with slight variations. Each crediting strategy has advantages and disadvantages for the client and the company; therefore, a method for crediting must be carefully selected keeping the seniors’ needs in view. The explanation of these methods and illustrations for the methods is essential for the client to develop a clear understanding on how these methods operate and how they can effect their investment.

Monthly Averaging

The performance of the index is averaged over a given period, i.e., daily, weekly, or monthly. Therefore, a monthly average would be calculated by looking at how the index performed in the past year. The advantage presented to the client is that sudden dips or downward slides in the index would not damage the investment to a great extent. At the same time, upward jumps would not be quickly evident to the annuity holder as well. In the longer term, losing upwards performance is something that can hurt the investment overall. The method is considered most suitable for a limited-time investment in a volatile index.

Point to Point

There are two main subdivisions of this method, annual and long-term. Both methods begin by identifying two points on which the difference between the index values will be used to calculate the gains. For example, the annuity using

Selling Annuities to Seniors 47

an annual point to point crediting method would see a gain of 22% if the index started the year at 9,000 and ended at 11,000.

With the annual point to point system, the interest rate is reset at the beginning of each annuity anniversary year. With the long-term point to point method, the interest rate is calculated using the gains made in the index over a longer period of time (5-10 years) without resetting the rate. The difference between the

methods is important for seniors, because the long term point to point method is most beneficial when the market is expected to keep an upwards trend. The annually resetting point to point method is more useful where the market is unpredictable or volatile.

For example, in Chart 1, the index goes from 8,000 points to 14,000 points in seven years. If the long-term point to point crediting method is used in this scenario, the gain would be 75% over 7 years.

High water mark

The interest rate under this method is calculated by looking at the highest point achieved by the index in the term. This method is similar to the point to point method because the term used to calculate the “high water mark” is an annual term. The best advantage for the senior is that the high mark is fixed to the rate on the annuity regardless of what the lows might be. This is a good crediting strategy for investors who want to invest when the market is soaring.

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As shown in Chart 2, the index goes from the stating point of 8,000 points to 13,000 points in seven years. The high value of the index came in the fourth year of the annuity when it was valued at 15,000 points. The gain would then be calculated using the difference between 8,000 and 15,000, resulting in a total of 87.5% gains over seven years.

Annual Reset

The method is used to provide a safety net against sudden financial changes.

The annual reset fixes the returns on an annuity to a pre-defined level. For example, suppose a person had an index-linked annuity where their variable account held 90% of the annuity value and a minimum return of zero. If, in the first year, the index gained 10%, their return would be 10%. However, if the index lost 10%, their loss would be zero because of the annual reset in interest rates.

This is a popular crediting method amongst seniors because it helps the annuity in up markets and protects the funds in the down markets.

Combination Methods

A combination method, as suggested by the name, combines the properties of the point to point and annual reset methods. It is further divided into a multi-year reset method and the average end multi-year reset method. The multi-year reset method is the same as the point to point method, except that the term for

calculating the return is two years or more.

The average end multi-year reset method looks at the average index level during the last month or two of the year. In essence, it looks at the average end of the index level at the end of each year. At the end of the term, the rates obtained for each period are combined and applied to the funds in the variable account.

Impact of Market Changes on Indexed Annuities

Quite possibly, a senior who has gained information about the rising stock market from various media sources might decide to invest in an indexed annuity. The senior may be aware of the advantages an index-linked annuity provides if the

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market falls, but does not realize that dividends from investments in stocks are excluded. If the senior has low risk aversion, he/she might later reconsider his/her decision and start thinking about variable annuities. A convincing argument in this case for indexed annuities is that dividends have a positive effect on indexed annuities as well, although that effect is not obvious.

The price of a stock depends on several factors, including the dividends; stocks within an index which is gaining value are likely to give out higher dividends to investors. Higher dividends mean that more investors will be attracted towards buying stocks from the same index. In the long run (as most annuities are long term investments), the index might make gains based on the dividends returned on its stocks. With a rising index, the insurance companies feel more comfortable in upwardly adjusting the participation levels they offer to the annuitants. If the senior is able to wait and adjust their participation levels to where they are satisfied with the risk they take, it could be better for them rather than trying to get out of an annuity by paying the surrender charges.

When the stock exchanges are retreating or staying bearish, indexed annuities come to the forefront with their minimum interest rate guarantees. The main risk taken by the annuitant is the uncertainty of the index performance, which can be countered by careful selection of the interest crediting method. It would be best for an investing senior if the interest rate is reset annually in a downwards

market, while the point to point method will outperform an annual reset method if the markets are rising.

The most important point for an agent with regard to interest crediting strategies is that regardless of the method chosen by the senior, he/she must understand and appreciate the implications of the method selected. Even though this is a risk taken by the consumer themselves, unless they fully understand what will

happen to their money, they might think that they have been cheated if the

returns are less than expected. That could lead to legal issues and even worse, a loss of reputation for the agent and the company itself.

Spreads

The spread is also known as the margin or administrative fee. This is a fee that the annuity seller charges on the gross interest rates, which result from the index gains. For example, if the index gains give a gross interest rate of 9%, while a spread of 2.5% is levied on the gains, then the net interest rate applied to the funds in the annuity would be 9% - 2.5% = 6.5%. Quite often, the insurance company will only apply the spread if the index shows a net gain and cover the loss if the index falls.

Cap

The indexed link annuity often comes with a limit on the interest that can be credited to the variable account. Annuities where the interest rate is annually reset most commonly use caps. This places the investor at a disadvantage when

Selling Annuities to Seniors 50

the market is experiencing bullish trends and to counter this, insurance

companies adjust the cap annually. The cap can rise or fall depending on how the insurance company manages its own investments. The cap is often used in conjunction with participation rates.

Effect of Imposing a Cap

Consider a situation where an index rises from 500 points at the beginning of the annuity to 1350 points at the end of the seven year term. The index has grown at a total ratio of 2.7, which means that the annual growth rate was 15%. If the annuity was capped at 15%, that would be the breakeven rate under the point to point crediting method and would have no adverse effect on the gains in the annuity. However, with an annual reset crediting method, the returns would be capped between 10% - 8%, depending on the performance during that particular year. The benefits of a cap to the insurance company become more evident when the insurance provider allows for a higher participation rate in rising markets.

In some annuities, caps may be imposed for the life of the contract. An annuity with an annual reset crediting method could permit for an annual adjustment of the cap and the participation rate.

In document Selling Annuities to Seniors (Page 46-50)

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