Read my previous articles on FIA Interest Crediting Methods including point-to-point and participation rate.
Another method for increasing the participation rate without introducing a cap is to add a spread to the FIA interest-crediting formula. Continuing with our same simple example in which we found a 56 percent participation rate, suppose the insurance company could offer a 75 percent participation rate with a 2 percent spread. What this means is that the FIA provides interest of 75 percent of the market gain less 2 percent, but still with the same principal protection in place. In this case, the index would need to experience a 2.67 percent gain before interest is credited because 75 percent of 2.67 percent is 2 percent.
The spread allows for a higher participation rate because it allows for the call option to be purchased with a higher strike price and therefore at a lower cost. In this example, the strike price for the call option can be 2.67 percent higher than its current price because the option only needs pay interest once this level is exceeded to meet the terms of the FIA. In this simplified example, this outcome could have been determined if the price for the call option with that higher strike price is $2.61. Then the options budget allows for 75 percent of an option to be purchased, providing 75 percent of any gains above 2.67 percent.
Another variation on interest-crediting for these one-year point-to-point FIAs is to introduce a buffer. But, again, to be clear, this will change the FIA into a variable index annuity (VIA) because principal is not protected. Buffers may reduce downside losses, but they do not provide principal protection. For instance, a VIA that provides a 10 percent buffer would mean that the interest credited is zero percent for any index loss between 10 percent and 0 percent. If the index loses more than 10 percent, then this approach would credit the amount of the loss in excess of 10 percent. For instance, an 18 percent loss on the index would lead to a loss of 8 percent for the VIA, but an 8 percent loss for the index would lead to no loss for the VIA. Accepting this greater downside risk can support more upside potential. But because these types of buffer VIAs do not create a floor for returns, they do not share the same general philosophy about how FIAs are known for providing principal protection.
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Other Fixed Index Annuity Crediting Approaches
The crediting method we have described thus far is a term end-point method with a reset for each subsequent term. We mostly considered an annual point-to-point design but explained that longer terms are also possible. This method only compares the end point to the start point and ignores any gains or losses in between these points.
There are countless other crediting methods also used in practice, although some of these may be quite rare. Jack Marrion and John Olsen provide a more detailed explanation about a wide variety of crediting methods in their book Index Annuities: A Suitable Approach. For the purposes of understanding how FIAs work, I do not think it is necessary to explain other methods in detail, but I recommend the Marrion and Olsen book for those seeking further details. We will consider a few other methods.
Yield spread design
Another possibility is to use a yield spread over the term. Instead of choosing a cap to obtain 100 percent participation rate up to the cap, the insurance company could instead determine the spread that would allow the options budget to provide full participation above the spread. The compounded return over the term is calculated, and then a yield spread is deducted from this to determine the interest that will be credited. In the annual case, if the index returned 7 percent and the spread is 4 percent, then the annuity would be credited with 3 percent interest. If the return is less than the spread, interest credited would match the floor value.
For instance, if the floor is 0 percent, the spread is 4 percent, and the return is 2 percent, then the interest credited is 0 percent. This method could provide more interest than a participation rate when gains are large, but it is likely to be less when gains are more moderate.
High watermark design
Another possibility is to focus on high watermark values during a term to determine interest, but this method is more expensive and is not common.
Rolling average design
Another possibility is a rolling average of index values during the term. An example of this could be a monthly method to credit interest based on the average value of the index at the end of each month during a longer term such as a year. These averaging methods will moderate the interest credited relative to term end-point methods. Averaging drives the index values toward the middle with both gains and losses, which means that a higher participation rate could be offered than otherwise with everything else being the same.
Monthly sum design
A more extreme and potentially confusing method is called monthly sum. Each month, upside growth has a cap, but there is no monthly floor. At the end of the term, the monthly values are added to determine the interest credited for the term. If the monthly cap is 2 percent, the interest could be as high as 24 percent for a year, but this would be a very rare event. It would require consistent gains of over 2 percent for each month of the year. If the index was up 3 percent each month for eleven months, but lost 25 percent in the twelfth month, then the interest credited for the year is 0 percent, assuming a 0 percent floor. This method’s best opportunity to work is to experience steady upward growth without any market dips.
There are other methods as well, and this discussion provides just a taste of the possibilities.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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