Fixed Index Annuities- Crediting Methods
Fixed Index Annuities are different from other types of annuities. The biggest difference is the interest crediting method that is used. Regular fixed annuities credit interest at a fixed amount that is stated in the contract. Fixed index annuities credit interest using formulas based on the changes in chosen indexes that are linked to the contract. The formulas determine how much interest, if any is calculate, earned and credited to the annuity. The amount of interest and when it is credited depends on the contract provisions in each individual annuity.
In a fixed indexed annuity, the insurance company purchases high rated bonds to cover the guaranteed part of the contract. The earnings from the bonds are used to cover company expenses and profits and purchase index call options. This allows the policyowner to participate in upward movements of the stock market but have none of the downside risk.
The first crediting method is the long term point to point. In this method, the index recorded at the policy effective date and at the end of a term such as one year, five years or seven years. The difference in the beginning and ending points of the index is the basis for the index gain or loss. This method works best when the market has steady growth over a period of years. Market fluctuations between the beginning and ending of the index period have no effect on the ending index calculation.
The high water method is decided by looking at various index values during the term period. The interest credit is based on the difference between the highest index value and the index value at the end of the term. The low water mark is measured by looking at the lowest point and the ending point of the term. Both of these methods credit interest at the end of the term.
With the annual reset method, the index at the beginning of the year is compared with the end of the year index. The ending rate then becomes the beginning rate for the next year and any credit from the previous term is locked in. Any previous years gains can never be lost and zero would be credited if the index declines.
Most of the crediting methods use a form of averaging. In some annuities, the average of an index is used instead of the actual value on a specified date. For example, in a monthly point to point index, the sum of each month’s performance is added together for a year. So even if the market had some bad months it is possible to end up with a gain. The opposite is also true. Months of good gains could be wiped out by one very bad month.
Most fixed index annuities have several indexes to select from. The Dow Industrial Average, Russell 2000, Standard and Poor’s 500 and NASDAQ 100 are just a few and sometimes your account can be allocated between different indexes and crediting methods allowing for more diversity and flexibility.
In summary, understanding and selecting a crediting method for fixed index annuities is very important. Terms can vary from one year to ten years so proper retirement planning is necessary. Make sure your agent clearly explains all the options that are available.