How Index Annuity Performance is Calculated

Index-Annuity-Performance-CalculationsThe financial performance of an index (or fixed indexed) annuity is linked to the performance of the stock market. Notice, the word “linked” is used. Depending on the type of index annuity you chose, the performance can closely follow the overall performance of the stock market (as measured by the S&P 500 or another index) or loosely follow it.

In general index (or fixed index) annuities are designed to generate an annual return of around 4-6%. This is a little less than the long term return of the stock market.  There is however no guarantee this level of performance will be achieved. You are however guaranteed that you will not loose your principal investment.

Some annuities have what is called a “participation rate”

An 80% participation rate would mean that you would get 80% of the gains of the stock market index.  What you get in return for giving up the additional 20% of upside is a floor which guarantees your account against loss.  Generally the floor is around 1% a year, so even if the stock market has a negative year, your worst case is a 1% positive return.

There are three main methods of how investment returns can be added to your index annuities.  With the exception of the performance trigger method (outlined below) these can also be combined with a participation rate.  Generally if you see an annuity which includes both one of the below methods and a participation rate however it is a good idea to avoid that annuity.

Here are the methods, in order of how closely (in general) they track the market:

1.  Point-to-point calculation

If you are a long-term bull on the stock market, you might want to consider the point-to-point method.

With the point to point method, you measure the rate of return of the market between two points in time.  The two dates can be set apart by a month, a year, or even 3 years. The positive or negative return over the time period chosen gets added to or subtracted from your annuity.

The point-to-point method almost always has a minimum rate of return (a floor) and maximum rate of return (a cap). Lets say you picked an index annuity which used the point-to-point method on annual basis. This annuity could have a performance floor of 1% and performance cap of 7%. Lets see what would happen with the annuity, under different market scenarios:

  • If the market loses value, or, gains less than 1% (the floor), then the  annuity will gain 1%
  • If the market gains between 1% (the floor) and 7% (the cap), then the performance of the annuity will be the same as the market.
  • If the market gains over 7% (the cap), the annuity will gain 7% regardless of how much more than 7% the market gains.

For annuities where the periods being measured are one or more years, this calculation can be straight forward. Things get more complicated when the periods of time are shorter in duration. The floor usually applies to an annuity’s performance over the period of a year. However, with monthly point-to-point annuities, the cap applies to the monthly gains. This can create situations in which negative months can easily offset gains made in positive months.

Because of this, in general if you select a point-to-point, we don’t think monthly point-to-point is a good idea.

2.  Monthly averaging

If you are generally bullish on the stock market, and don’t like short-term volatility potentially having a major impact on your returns, you should consider the monthly averaging method.

You calculate the twelve monthly changes in the stock index (both positive and negative). Then add them together and divide by 12.  By definition, you will get a number which is higher than the lowest number, and lower than the highest number. That is your return.

However, monthly averaging usually has both an annual floor and cap. We generally don’t like monthly averaging because it undermines the key premise behind investing in the stock market. That the market goes up over time. As the floor limits your downside, we think that averaging is an unnecessary protection against risk that limits your upside.

3. Performance trigger

A Performance trigger is radically different than the other methods for calculating gains. The performance trigger method almost always looks at the performance of the stock index over the period of a year. With the performance trigger method, you ask one question:

Was the performance of the stock market positive or negative over that period of time?

How positive or how negative is not relevant to your performance gain. If the answer is positive, you get a pre-determined return (typically between 4-6%). The market could have been up ¼ % or 14%, your return would be the same in either case. If there is no positive change, then no return is credited to your account for that period. If you think the stock market will rise by small amounts for the coming years or will be relatively flat, the performance trigger may be the most suitable.

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