I have two healthy houseplants in my office. But they weren’t always so healthy — it took some time for me to understand that one plant thrives in direct sunlight, while the other does best in indirect light. That doesn’t mean that one plant is “better” than the other — they simply thrive in different environments.
Regarding indexed annuities, I’m often asked, “Which index crediting strategy is best?”
Like with plants, there is no best strategy. Different index crediting strategies thrive in different environments.
Rather than try to project the best index strategy — because you really can’t — a better approach is to allocate among index crediting strategies based on the anticipated environment. Here is a three-step approach to better understand the environment in which various strategies thrive the best.
Step One — Index Type
Since fixed indexed annuities were introduced, stock market indices — such as the S&P 500 and others — have been the standard. More recently, volatility-control and hybrid indices have gained popularity.
A big difference between volatility-control and stock market indices is the cost of the call options. Reduced volatility lowers the cost of call options for the insurance carrier, allowing higher participation rates to be offered on volatility-control strategies. While a volatility-control index’s raw growth may be lower than that of the stock market index, the client may be able to capture more of the growth in a volatility-control index due to the higher participation rates.
I am not suggesting that one type of an index is better than another, but it is important to understand where the differences lie between the two types.
Step Two — Index-Tracking Model
How does the index strategy measure growth for crediting purposes? Point to point? Daily or monthly averaging? Monthly sum cap? The environment impacts each strategy differently.
Point To Point
» Advantage: When an index has strong and steady growth for the year, point to point may do very well.
» Disadvantage: An index could see strong growth throughout the year but then taper toward the end, or worse, have the ending point (client’s anniversary) fall on a day like March 20, 2020.
» Advantage: When an index has been volatile throughout the year and ends lower than where it started, averaging sometimes can help prop up some growth for the year. Because there is a little bit of volatility control going on in averaging, a carrier generally can provide slightly higher crediting rates compared to point to point.
» Disadvantage: Averaging can water down the growth of an index that is having a strong and less-volatile year.
Monthly Sum Cap
» Advantage: When an index is growing month over month over month, this strategy can provide a very strong return.
» Disadvantage: Most indices don’t grow at a 45-degree angle. One bad month can wipe away several months of growth.
Step Three — Crediting Mechanism
What calculation is applied to the index growth to determine a crediting rate? Cap rate? Participation rate? Spread? And, of course, what rates are offered with the various strategies? The environment impacts the crediting strategy as well.
Cap Rate vs. Participation Rate
In a lower-growth year, a cap may do better by capturing all the growth up to the cap. Otherwise, with a participation rate, you are getting only a portion of that growth. In a stronger-growth year, the participation rate might do better than a cap because, at a certain point, the index return caps out.
Cap Rate vs. Spread
Again, in a lower-growth year, a cap might do better because you are getting all the growth up to the cap, where in that same situation, a spread might eat up all or a good portion of the growth. In a strong-growth year, a spread might do better, since any growth beyond the spread is captured.
Participation Rate vs. Spread
In a lower-growth year, participation rate is going to capture some growth, where the spread may absorb most or all of that growth. Both are poised to perform better in a stronger-growth year; however, the spread must be at a level where the growth beyond the spread is better than the participation.
Diversify, Diversify, Diversify
Someone once said diversification is the closest thing to getting a free lunch. The beauty of indexed annuities is the broad choice of accounts — and various combinations of indices, tracking strategies and crediting mechanisms. Rather than pick just one index account, consider allocating among several accounts. But don’t diversify just for diversification’s sake — diversify with your client’s outlook in mind.
Bullish outlook. For a client who believes the markets are poised for a very strong year, point to point, participation rate and spread may be better positioned.
Bearish outlook. For a client who believes the markets are not poised for a stellar year, averaging and cap rate may be better positioned.
Ambivalent outlook. For a client who might like to hedge, perhaps combining point-to-point participation with an averaging cap can cover them for either type of market. And don’t count out the fixed interest rate option; sometimes having a little in there can at least provide a little bit of guaranteed return — or cover the costs of an income rider fee.
In addition, when you look at a stock market index versus a volatility-control index, both can thrive in bullish and bearish times. Both will probably thrive best in less-volatile markets.
Because no one has a crystal ball, diversifying among multiple strategies and indices can provide the best chance to produce steady accumulation. Diversifying upfront reduces the temptation to chase past results by reallocating each year.
Index Annuity Downside Protection
And finally, if there is one thing I can’t emphasize enough — sell the safety first! Indexed annuities offer rates linked to the results of various indices without actually investing in those indices. Index credits are never less than zero, which means clients are protected when indices decline.
Upside potential and downside protection. When that foundation is laid down first, you will manage your client’s expectations more effectively and make annual reviews go much more smoothly.
The other day, my wife caught me talking to my plants. I’ve heard talking to plants helps them grow. I wonder if talking to your index crediting strategy could have the same effect? “Who’s a good point-to-point participation strategy? You are ... yes, you are ... YES YOU ARE!”