By John Rafferty
Oct. 4, 2010 -- The basic value proposition of indexed annuities has remained fairly stable since their introduction 15 years ago. The contracts have traditionally offered a comfortable mix of principal protection and upside potential, offering greater upside potential than traditional fixed annuities, without the threat of principal loss if held to the end of the surrender charge period.
While recent product development efforts by many issuers have focused on adding income benefit riders – which in turn have driven much of the business in recent years – the basic product value proposition of upside potential with downside protection remains for those focused on accumulation objectives. That being said, with current interest rates on traditional fixed annuities at multi-year lows, the cap rates offered on indexed annuities have also followed suit. In particular, the annual index caps on point to point crediting methods are a good example of how far these rates have fallen, with many products today offering annual cap rates of 3 to 5 percent in this environment.
Sure, that upside potential is higher than what is offered on many traditional fixed products, yet it is low enough to bring to mind an old advertising slogan from the mid-1980s questioning the whereabouts of a beef patty on the typical hamburger.
That ad suggested that while the common hamburger seemed to lack value, substance does indeed still exist for those who are willing to try something different. In similar fashion, the upside potential – I stress potential - of indexed annuities can be strengthened for those willing to examine alternative index interest crediting methods. One such method is called the monthly averaging with spread, and in low-cap rate environments like we are experiencing right now, this method may provide more substance to the upside potential of index annuities.
Because there are more moving parts in this index interest crediting method than the annual point to point with cap, it’s no surprise that this method has been less popular. But once you learn how this crediting method works, you will see it certainly offers more potential to the upside than the 3 to 5 percent rates offered today by annual point-to-point with cap methods.
In a nutshell, here’s how this crediting method typically works: You add up the 12 monthly ending values of the index being used - most commonly the S&P 500 Index – and you divide this sum by 12 to get a monthly average. If the sum of the monthly ending index values adds up to 12,000, the average monthly value would be 1,000. This average monthly ending index value of 1,000 is then compared to the beginning index value on the date of contract issue -- let’s assume it’s 800 – and the difference of 200 is divided by the beginning value of 800. This would result in an increase of 25 percent - from 800 to 1,000. However, we have to subtract the spread from this, and let’s assume the spread is 10 percent. The final indexed interest amount credited to the contract in this case would be 15 percent. While returns like this example may not be the norm, the point is that if the stock market can move as strongly upward over the course of a year as it can move in the opposite direction, why not harness that upside potential with a crediting method that can take better advantage of a such a potential large scale rise, all the while being protected from losses no differently than other crediting methods?
Behavioral Economics and Choice of Index Crediting Methods
The study of behavioral economics as it relates to financial decision making has come into vogue in recent years as markets have become more volatile and researchers look for clues as to what drives the financial decisions of individuals. Loss aversion is a hot topic in this field and refers to the strong tendency to prefer to avoid losses rather than to acquire gains, with some studies suggesting that loss aversion is twice as powerful, psychologically, as the hope for gains.
However, as we discuss the pursuit of greater upside potential, loss aversion should not have as powerful a role in the decision process in the context of indexed annuity contracts. The reason for this is simple: regardless of the index crediting method selected, the risk of loss in indexed annuities typically remains at zero if the contract is held for a specific time period.
Why Bunt When You Can Swing for the Fences?
As we approach the baseball playoff season, discussion of bunt situations may become more prevalent. As we know, bunting is a batting strategy employed mostly in close games where you are really playing it carefully, and are more interested in not losing than in winning big. In fact, you are so interested in not losing that you are willing to sacrifice an almost a certain out in order to advance the runner(s) by one base. Rather than swing hard and potentially drive in a few runs with one good swing, you choose to bunt.
Now let’s assume some invisible baseball genie comes to you as you leave the on-deck circle for the plate, with one out, runners on first and second, in a tie game where your coach gave you the choice to bunt or swing. But the genie says to you: “I can’t tell you if you’ll win the game, but I can guarantee you won’t lose it no matter what you do. It’s your choice.” In that situation, why wouldn’t you go for it?
In similar fashion, the monthly averaging with spread crediting method is the indexed annuity version of swinging for the fences. With no predetermined upside limit and the same protection against losses as the annual point to point with cap, the monthly averaging with spread index crediting method deserves a look. Not unlike choosing to take a full swing instead of bunting, it's a tactical choice that may be right for the times.
John Rafferty is vice president of Marketing Account Management for American General Life Companies, oversees marketing strategy and communications for life, individual and group annuity, and Accident & Health business lines. American General Life Companies, www.americangeneral.com, is the marketing name for the insurance companies and affiliates comprising the domestic life operations of American International Group, Inc. American General Life Companies insurers offer a broad spectrum of life insurance, fixed annuities, accident and health products and worksite benefits to serve the financial and estate planning needs of customers throughout the United States.
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