Thursday, August 16, 2007

An example of an FIA crediting method

Yesterday I started writing about one of my favorite retirement savings vehicles, the fixed-index annuity.

So how does an insurance company credit an FIA contract with interest?

One popular design is the annual point-to-point reset design. Let me explain how this works.

This annuity takes one measurement of the index on day one, and another measurement exactly one year later (though some take an average of everyday over the last month). The difference in the index value is calculated and a percentage of change is determined. As an example:

Assume on December 31 2007 the index in the contract has a value of 1000. Assume on December 31, 2008 the value of the index is 1100. The difference is 10 percentage points. Theoretically the insurance company would credit all those contract holder's that purchased their annuity on December 31 with a ten percent increase. But, if you remember from yesterday the annuity never gets the full growth of the index, only a portion.

Right now some of my favorite point-to-point contracts are utilizing what they call a participation rate to limit the gain of the contract.

Let's look at the example again and let's assume a 50% participation rate. The policy would credit a 5% gain (50% of 10%).

And on December 31, 2008 the new index value is 1100 and the next year's gain or loss will be measured against the 1100 value.

If you had purchased an annuity with $10,000 the value would now be $10,500. Of course if you were able to buy the index itself with your $10,000 it would now be worth $11,000.


Now let's take a look at what happens in a down year.

Assume on July 31, 2007 the index value is 1000 and on July 31, 2008 the value is 750. What interest rate does the annuity contract credit? 0%. While those that purchased the index directly had a 25% loss, the index annuity didn't lose anything. And as an added bonus, the new starting point is 750. So any gain or loss for the year 2008 will be measured against the 750 index value.

If the next year (July 31, 2008 to July 31, 2009) the index goes from 750 to 800 the index annuity with a 50% participation rate would credit about a 3.5% gain. If you had bought the index directly in on July 31, 2007 you'd still be down 20%.

With a $10,000 purchase, the index annuity value would be $10,350 while money that bought the index directly would be value at $8000.

And that is the reason I like index annuities so much. If I knew what the stock market was going to do each year, I wouldn't buy an indexed annuity, ever. If I knew the stock market was only going to go up, I'd buy as much of the index as I could afford, I might even be tempted to borrow some money to invest.

But that's not how the market works. Sometimes it goes up, and sometimes it goes down. Personally I do own some stocks and some mutual funds. But I also own a few indexed annuities. I like to have some money that I won't ever lose.

I hope the clears up a little confusion on fixed-indexed annuities. Of course there are bunch of different ways FIA's credit interest, this is just one of the options.

No comments: