How To Choose Annuity Indexes
Almost everyone who buys and indexed annuity wants to know how best to choose an index that will offer maximum performance. After all, you want to make as much money as possible, right? When an indexed annuity has several options it can be hard to decide which is best to grow the money over time. Several people have asked about this so it’s a good topic to cover. I don’t mind you asking these questions if you buy something from me but those who choose something else often come back because the salesperson isn’t available to help at every contract anniversary. This will be a good reference point for first-time buyers and anyone who has a deadbeat agent.
First of all, you get to allocate the funds to any combination of available indexes and at every contract anniversary you get to change it however you see fit. If a contract has ten index options you can put 10% of the funds in every single one or 100% in just one of them. Any other combination that falls in the middle is ok so long as all funds are directed to an allocation. I’ll cover all the options available and how you need to analyze the different types of indexes.
Every single contract has a fixed rate as one of the options. Since the building blocks of an indexed annuity is a fixed annuity then guaranteed interest is always going to be part of it. This is a good choice if you lack confidence in the market going forward but you want to maintain potential with other indexes in the contract. Many people choose to put a portion in the fixed account just so the contract value is always moving forward. For those who like to frequently check account balances this will ensure you always see the money growing every time you login to the account.
Cap Rate, Participation Rate Or Spread?
A long standing argument between both consumers and advisors will always be had over whether a cap rate, participation rate or spread is the best way to calculate interest. The correct way to look at it is to realize that each of them have an advantage in certain times. Cap rates are a maximum amount of interest that can be earned and work best when market movement is positive but not astronomical. If the market moves up by an average amount then your cap rate will give you most, if not all of the yield. In years where the index moves well into double digits then you’ll be better off with either a participation or spread with the spread offering the highest topline performance. Most options with a participation rate or spread have unlimited potential and many agents sell that potential but it’s risky to set expectations that high and a contract with good cap rates as well is the best way to ensure you can capitalize in all markets.
Pure Equities vs. Blended Indexes
When you track a pure equity index like the S&P 500, NASDAQ, Dow Jones or Russell 2000, it’s easy to verify and track your potential gains. If the market is up then you’ll get a piece of it. I have mostly gone to projecting illustrations on these indices because it’s easy to understand. Sure I can show bigger numbers, and a lot of agents do, but is it realistic? Blended indexes are administered by investment banks and have components of bonds, cash or treasuries and the employ risk control strategies to limit volatility. I’m not going to go into a full dissertation on that because I covered it in a podcast last year. Check that out for a deeper explanation. From August 30, 2023 is Crazy Annuity Indexes.
The blended indexes typically have more consistent rates and the partnership between insurance company and bank ensures a long-term pricing agreement. You won’t see as many rate adjustments here because options pricing is consistent and most of the indexes are not built to grow aggressively. You have to understand that many of the fancy illustrations you’ll see are based on a cash or bond component with consistently falling interest rates. In order to repeat performance you would need to replicate both market returns and interest rate behavior going into the future. That’s not likely to happen. Almost all blended indexes over the past two years have been more or less flat, leading to disappointed policy holders because this wasn’t explained properly. I try to educate everyone ahead of time so recall a podcast from early last year that covered this topic completely. From March 24, 2023 is BS Annuity Illustrations.
Risk control measures also mute returns. It can be good in volatile markets, giving decent returns when the market is flat or negative but will lag behind when the market is really charging forward. Most of the blended indexes have a 5% volatility target and if you look at the podcasts above you’ll see why that offers very conservative returns. There are a few indexes that come with 10% or 12% volatility targets and those will move more aggressively. Allocations to any of these indexes will depend on what the index offers on the safe side. Cash is less interest rate sensitive than bonds and a higher volatility target will offer more growth potential. If interest rates continue to be volatile then most of these should be avoided in the near future.
Alternative Indexes
Several of the contracts I like will give you options that are not at all related to stock or bond markets. There might be some correlation to the overall economy but there are periods of time when an alternative index gives you positive growth when it’s not available in the stock or bond market. Indexes based on commodities or real estate are a nice option to have so you can diversify the options or even attempt a positive credit when equities markets hold a grim outlook. 2020 until now has been good for Gold and Real Estate indexes with far more overall growth than you would have seen from the stock market.
How to Choose Each Year
There are three ways you have to make your decision each year. About half of the people I work with just tell me to do what I think is best but even then I make sure they understand what I’m doing and agree with the chosen direction. The analytical types are sure to overanalyze things and stress about the options every year. Laid back people just stick with what they have and prefer to let it ride, figuring I suppose that things will average out over time. This works will for the people who blend the allocations equally across several indexes and keep diversified holdings over time. This has shown to work well and really does eliminate a lot of the stress and decision making required.
Hopefully this gives you a decent idea of how to look at it. If anyone thinks it’s too complicated then you can always just buy a fixed annuity so you don’t have to deal with it.
Enjoy your weekend!
Bryan
Podcast Episode: How To Choose Annuity Indexes
Last Updated on April 26, 2024 by Bryan Anderson
