Explaining Annuity Crediting Strategies: Cap Strategy
A fixed indexed annuity (FIA) is a type of fixed annuity that uses the performance of an index to determine the interest that gets credited. A key characteristic that makes fixed annuities attractive is that they will not lose money from market performance. An FIA is no different, even though its interest is tied to an index.
Because these annuities promise that they will never lose money, the trade-off is that insurance companies must limit the upside potential. The different ways of calculating the interest based on the performance of the index are also known as crediting strategies.
Each crediting strategy has characteristics that affect how much the interest will be. These and other variables influence what fits the goals of the annuity buyer. Common crediting strategies include cap, participation rate, spread, monthly average, and monthly sum.
The crediting strategies can be used on a variety of different indices. Some of the indices are common ones that most people are familiar with, like the S&P 500 or the Russell 2000. Others may be less common and may be designed to have
consistent returns or lower variability. No matter what, all FIAs use a crediting strategy to determine what the interest will be at the end of each crediting period.
POINT-TO-POINT CAP STRATEGY
The point-to-point cap strategy measures the performance of the index from one point in time to another, usually starting the day you purchase the contract until a year later and then repeating the measurement every year(1). The strategy then uses a “cap” that limits the amount of interest, no matter how well the index performs. As with all FIAs, the interest in any year cannot go below 0%, no matter how much the index loses.
There are two key things to keep in mind when considering the selection of a crediting strategy. First, what do you expect to get out of the FIA? Any FIA guarantees that the account value will not lose money from index losses. The
cap strategy may credit higher than a bank CD or a declared rate fixed annuity. Anyone who buys an FIA has to tolerate the possibility that the actual credit may be lower than those alternatives, too.
The second thing to consider is what your “market conviction” is. Market conviction is the belief in how markets — in this case, the specific index — are likely to behave in the future. In the case of this kind of cap strategy, it’s important to remember that any index return over the cap doesn’t increase the amount credited to the FIA. That means that this strategy benefits when index returns are consistently positive. Big gains don’t matter. Some indices have returns that may not have high (over the cap) gains often but are consistent, which can fit well with a cap strategy.
The point-to-point cap strategy is one of various crediting strategies available on an FIA. Annuity Alliance will explore different strategies as well as factors that are important when considering the benefits of an FIA.
(1) Some strategies measure over more than one year, but we use one year for our examples because it is the most common.