The ‘Secret’ to Deciding on a Successful Crediting Method
Actuaries design the crediting methods available to you to give the carrier a strong profit (in the long run) from the growth in the index you use. This is not bad, per se, since they also guarantee against market losses and guarantee income for even extraordinarily long lives, even when your cash value exhausts. So, is there a secret to picking the likely best interest crediting method? Yes, if you are right about how volatile the index is likely to be over the coming year until you can switch crediting methods. Looking back at past performance, compared to the resulting interest credited for differing crediting methods, I have observed distinct patterns.
• If the market is more volatile than average from month to month, yet there is at least average growth by the end of a policy year, then the best method to have picked is annual point-to-point. This is typically so because it ignores the uncapped losses that occur along the way.
• If growth in the index is relatively calm and its growth is average or better, then monthly point-to-point captures all of those upswings and very few get limited by the cap.
• If there is growth, volatile or not, followed by a serious market correction (erasing most gains but finishing the year somewhat positively), then the best method is annual monthly averaging because the gains prior to the collapse are part of the interest calculation, even though the market topples near year-end.
Overall, if gains are strong and somewhat consistent throughout the year, then monthly point-to-point captures most of that growth for the year. This crediting method does not consider any monthly losses. Monthly losses do count against you in that there is no limit to the loss recorded for a month if your formula counts change each month.
How can carriers guarantee that equity-indexed interest will be zero or higher? Is your agent curious enough to know what backs such guarantees; that they’re not too good to be true?
A Big Secret
These EIA contracts are designed to use your money to earn the carrier strong returns by means of the carrier buying call contracts on the indexes that their EIAs tout. They use the money to buy call options from entities that have large portfolios, such as pension plans and certain banks. Buying calls with durations that match the interest crediting in the policy enables the carrier to pay interest if the index increases enough for it to pay interest; no loss to the carrier if the index failed to produce a gain. This method of behind-the-scenes investing secures reliably better gains for the carrier than bonds, mortgages, realty, and other assets. The carrier has reserves to cover transaction costs and lost call premiums while investing over the long haul to capture most of the long-term returns of these indexes. The upside is not limited; the downside does not harm the carrier, because it just lets the call expire. The dividends of the stocks in the indexes do not come to either the policy owner or the carrier because these call contracts are for the right to buy the stock, not the right to receive the dividend (i.e., the owner of the stock who sold the call to the carrier still owns the stock and so receives the dividends). The dividend lost is not generally huge: The Dow and S&P 500’s average dividend rate for the last sixty-five years was typically around 3%. Because this is fairly stable, the non-dividend index rate of change (used in EIA policies) is approximately the same as the growth rate including dividends.
EIA carriers share the call profit with the policyholders by means of a crediting formula that the policyholder picks. But since the upside of the call price is not limited and the downside is limited to the carrier’s loss of the call premium, they must have a reserve to replace lost call premiums and continue the process. The crediting formula provides better yields than bank and government bond yields in most years (depending upon the volatility and interest crediting method the policy owner picked). Calls can be laddered to help the carrier capture the longer-term upward bias of the index. This, plus the return sharing effect of these formulas (interest crediting methods), earn the carrier a good return most years. It earns money on its reserves and this technique limits its losses on the call premium it spent. The carrier (and policy owner) do not have to buy stock in the index; that could result in big losses. All of this combines to enable the carrier to confidently guarantee no losses to the policy owner while paying a superior return on the greater of the income account value or the cash value. The income account value only has meaning if the policy owner opts for lifelong guaranteed withdrawals. The long-term nature of all of this—especially with regard to the need to realize the long-term rates of return on the indexes rather than a period in which volatility hurts the carrier’s reserves—is why carriers have surrender charge schedules and also how they can offer strong, lifelong income guarantees. Again, there is no possibility of market loss to the policy owner, but the return trails the long-term potential of stocks. But the value to the consumer is not in rate of return; it is in the long-term guarantee of income. All of this reinforces my advice that consumers should split their money between income-and-principal guaranteed EIAs and some form of at- risk portfolio that captures a far better return over the many years of their investing lives.
There is much more to know about annuities, such as the income at retirement and how to pick the best ones, and the tax treatment. One must also understand that a market value adjustment could be applicable in both VAs and EIAs when moving money from the fixed-rate account to the indexes or VA separate accounts (because fixed-rate accounts are backed by bonds and these can gain or lose value with interest rate changes). But the foregoing are the main factors producing cash value for consumers; income guarantees are discussed in the retirement planning chapter. Remember, annuities are long-term investments that are not designed for funding college or anything other than retirement. If you own a VA, your investment strategy should mirror the asset allocation prescribed by the model for your retirement investments, not the asset allocation for shorter-term investment objectives such as saving to buy a business or saving for college.
