Index crediting strategy: Which one is best for your clients?

When it comes to choosing an index crediting strategy, there is no one-size-fits-all approach, according to Jeff Barnes, EquiTrust regional vice president.

Barnes presented a three-step approach to choosing the right index crediting strategy during a recent webinar held by the National Association for Fixed Annuities.

“Different index crediting strategies thrive in different environments,” he said. “And rather than trying to project the best index strategy, because you really can’t, a better approach might be to allocate among index crediting strategies based on the anticipated environment.”

Barnes discussed his three-step approach to better understanding the environment in which various strategies can thrive the best. Those three steps are:

1. Index type.
2. Index tracking model.
3. Crediting mechanisms.

Index type

Barnes said his first step is looking at the index type. “Since fixed indexed annuities were introduced, stock market indices like the S&P 500 were the standard,” he said. “More recently, volatility control and hybrid indices have gained some popularity.”

The cost of the call options is the big difference between volatility control and stock market indices, he said. “Reduced volatility lowers the cost of the call options for the insurance carrier, allowing higher participation and crediting rates to be offered on a volatility control strategy. With a volatility control index, while growth may be lower than that of a stock market index, the client may be able to capture more of the growth in a volatility-controlled index due to the higher participation rates.”

Barnes said he often explains volatility-controlled indices using a baseball analogy of “you probably have fewer home runs, but you also have fewer strikeouts and more singles and doubles.”

Is a volatility-controlled index better than a stock market index? Barnes said he isn’t suggesting that. 

“But I think it’s important to understand where the differences lie between the two types. When somebody looks at an index, it’s important to understand what drives that index. 

“And some of those volatility-controlled indices add more than just an equity base to them. They might have things like commodities or real estate or bonds and then cash. So again, I’m not saying one is better than the other. But it’s important to know how the two of them work.”

When looking at a specific volatility control index, Barnes said, an advisor shouldn’t rely on the best illustration or the best historical performance. “Make sure you have a good understanding of what the mechanics are behind the index,” he said.

Index tracking model

Barnes listed three different index tracking models, as well as the pros and cons of each strategy.

» Point-to-point. A point-to-point model performs well when the index experiences strong, steady growth, he said. But the downside is that this model is dependent on how the market is performing at the annuity’s contract anniversary date.

“A disadvantage to a point-to-point approach would be if the index sees some strong growth throughout the year, but then tapers off toward the end,” he said.

» Averaging. An averaging model can provide some index credits even through a year of market volatility, Barnes said. This model often has slightly higher crediting rates compared with a point-to-point model. However, he said, the averaging model doesn’t maximize index credits in a strong, stable year.

“Averaging takes out some of the high highs and the low lows,” he said. “Averaging sometimes can help prop up some growth for the year because there is a little bit of volatility control going on. In an averaging tracking model, the carrier generally can provide slightly higher crediting rates compared with a point-to-point track model.”

» Monthly cap. A monthly cap model provides a strong return when the index grows month over month, he said. But one bad month can eliminate several months of growth.

“With a monthly cap, when it hits, it usually hits really well, but there are times when it doesn’t — when you have some volatile months that wipe out the good months,” he said.

Crediting mechanisms

A crediting mechanism, Barnes said, is the calculation applied to the index growth to determine a crediting rate. 

“Is it a cap rate? Is it a participation rate? Is it a spread? And then, what rates are offered with the various strategies, the end-buyer environment impacts the crediting strategy as well.”

Barnes presented comparisons of various crediting mechanisms.

» Cap rate versus participation rate. A cap rate mechanism may perform better in a low-growth year by capturing all possible growth up to the cap, while a participation rate mechanism would capture only a small portion of that growth. But in a high-growth year, a participation rate may outperform the cap rate because it allows the ability for growth to exceed the cap.

» Cap rate versus spread. In a low-growth year, a cap rate may perform better by capturing all possible growth up to the cap, while a spread may limit or eliminate growth. A spread may perform better in a high-growth year, because all growth beyond the spread is captured.

» Participation rate versus spread. The participation rate will still capture some growth in a low-growth year, while a spread may absorb most or all of that growth. Both crediting mechanisms are strong options in a high-growth year, Barnes said. In order for the spread to perform better, it must be at a level where growth beyond the spread exceeds the participation rate.

The importance of diversification

“Someone once said, ‘Diversification is the only free lunch in investing,’” Barnes said. “And the beauty of indexed annuities is the broad choice of accounts, and various combinations of indices, tracking strategies and crediting mechanisms. Rather than picking just one index account, consider allocating among a few accounts. Don’t diversify just for diversification’s sake; diversify with your clients’ outlook in mind.”

For clients who believe the markets are poised for a strong year, Barnes suggested using a point-to-point strategy using participation rates. For clients who believe the markets aren’t poised for a stellar year, using an averaging strategy or using a cap rate could be better for them. 

“Because no one has a crystal ball, diversifying among multiple strategies and indices can provide the best chance to produce steady accumulation,” he said.

Sell the safety first

“If there is one thing I can’t emphasize enough, is sell the safety first,” Barnes said. “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. 

“With that foundation laid down first, you will manage your clients’ expectations more effectively and hopefully make annual reviews go much more smoothly.” 

Susan Rupe is editor in chief, magazine, for InsuranceNewsNet. She formerly served as communications director for an insurance agents' association and was an award-winning newspaper reporter and editor. Contact her at [email protected].