We have been extensively covering Fixed Indexed Annuities here on Advisorworld.
To recap, Fixed Index Annuities are contracts between the annuitant and an insurance company in which the insurance company promises to credit interest based on the performance of a certain stock market index. Fixed Index Annuities has an inbuilt feature of capital protection, so even if the index goes down, your principal will remain safe.
But, the most common question we hear is that “How does a fixed income annuity exactly make money for investors?”
We can determine how an FIA will make money by knowing its Interest Crediting Strategy. The insurance company specifies in advance the interest crediting strategy on the annuity we chose.
Interest crediting strategy specifies how and when the interest will be credited. There are various interest crediting strategies that an investor can choose from. Some of the popular interest crediting strategies are:
- Point to Point interest crediting strategy
- Monthly sum interest crediting strategy
- Monthly average crediting strategy, and more.
Out of these, Point to Point Annuity Strategy remains the most popular interest crediting strategy. We will briefly discuss Point to Point annuity strategy in this article.
What is a Point to Point annuity method?
A Point to Point interest crediting strategy uses the growth of an index from one predefined point in time to another point to determine how much interest will be credited to the policyholder. If the index has given a negative return, the investor doesn’t lose his principal.
A few things worth noting before investing in an annuity with a point-to-point interest crediting strategy are Index Selection, Cap Rates, Participation rate, and Spread.
Index Selection: Gone are the days when Indexes’ were just limited to S&P 500 and NASDAQ. There are a plethora of indexes that are available now – Bond Index, Real Estate Index, Commodities Index, Volatility Index, and whatnot. Different FIA plans offer exposure to different indexes; so, it is always important to identify your goal and chose your index to fulfill that goal. For example, you feel that markets will be volatile in the next few years – so, you can invest in an FIA that has VIX (Cboe Volatility Index) as its Index.
Cap rates: Cap rate is the most important terminology in an FIA. It means at what rate your interest-earning capacity is capped. For example, if an index returned 13% but your contract’s cap rate is 7%. In this situation, You will be eligible for an interest credit of 7% only. It doesn’t matter how much the index goes above the cap rate; the maximum interest you can earn is the cap rate. However, insurance companies are trying very hard to sweeten the deal for annuity investors. We are seeing that many companies are starting to offer “uncapped” plans.
Participation rate: Participation rate describes the annuitant’s participation percentage in a return of an index. For example, suppose the participation rate is 60%, and the index returned 10% over the agreed time. In that case, the annuitant will be eligible for only 60% of the return, i.e., 6%.
Spread: Spread is the percentage of the index return that the insurance company will deduct from your interest calculation. For example, if the spread in the contract is 2% and the index returned 8%, you will be eligible for the return minus the spread (8% – 2%), i.e., 6% of the return.
The below graphic helps us understand a Point to Point interest crediting strategy in conjunction with the above points.
In a Point to Point interest crediting strategy, there are different durations/time period methods. We can have an annual point-to-point method, a two-year point-to-point method, and so on. Investors who want to minimize the volatility between two points should choose a longer duration crediting method.
Let’s consider a hypothetical example to understand the concept better. On January 1, 2015, An investor purchased a $10,000 FIA with an annual point-to-point interest crediting strategy. The index is S&P 500, the Cap rate is 8%, the Participation rate is 120%, and there is no spread.
The following table shows the returns on the annuity for the next six years.
|Year||Initial Value||S&P Return (1 Jan – 31 Dec)||Participation Rate||Annuity Cap||Annuity Gain||End Value|
An annual point to point interest crediting strategy
Investing in Fixed Income Annuities (FIAs) is a good way to participate in the markets without bearing the principal risk. A long period point-to-point interest crediting strategy ensures that the effects of short-term volatility are minimized. The worst thing that can happen with your annuity is that you gain nothing between two points; you don’t lose anything.