Before the fact, the various crediting methods available should be approximately equal in terms of long-term performance. Performance after the fact will be different as the actual index return will be translated into different interest credited as based on the crediting method. But before market performance is realized, the different methods are all using the same options budget to purchase financial derivatives that are priced with the same inputs.
Companies face the same market prices for options and interest rates. While companies can be creative about designing their crediting methods, at the end they have to use similar methods to support the guarantees and upside offered. This means that the parameters (such as participation rates, caps, floors, or spreads) will have to be adjusted to match the reality of interest rates and option prices. Different crediting methods are just different ways to bundle these parameters together. One method is not inherently better than another. The different methods just structure the returns of the index differently when calculating the interest to credit. After the index performance is known, there is a crediting method that will have worked best with it.
To better illustrate this, we can consider an example of a one-year point-to-point crediting design with a participation rate or a cap. Is a cap combined with a 100 percent participation rate better than having a lower participation rate but with no cap? Before we know the realized index return, it does not make a difference if both FIAs are priced competitively based on options pricing. But after the fact, one will perform better. The capped FIA will do better when returns are positive but lower, while the participation rate FIA will do better when higher returns are realized. In fact, there is a formula that can determine the break-even return for this calculation. Suppose FIAA offers a participation rate and FIAB offers a cap rate. The break-even return needed for A to outperform B is:
With our earlier simple example, we discussed A as having a participation rate of 56 percent and B as having a cap rate of 6 percent. This formula then leads to a break-even return of 10.7 percent. If the price return on the index exceeds 10.7 percent, then the owner is better off with A that offers a lower participation rate but with no cap.
A 15 percent return, for instance, means that A credits an 8.4 percent gain while B’s gain is capped at 6 percent. But if the price return falls below 10.7 percent, then the owner is better off with B even though the return is capped at 6 percent. A 10 percent index return, for instance, only credits a 5.6 percent return for A but a 6 percent return for B. If the index gained 5 percent, then A would credit a 2.8 percent gain versus a 5 percent gain credited for B.
Exhibit 6.1 helps to illustrate this. In broader terms, introducing principal protection with a cap leads to the creation of two posts. Returns will tend to fall at either the floor or the cap with fewer returns in between. The participation rate version without the cap will instead have a broader range of returns above the floor. This may lead it to have higher volatility for the returns, but that is reflected more on the upside, as large positive returns will provide bigger gains for the participation rate version.
Exhibit 6.1 Comparing FIAs with Participation Rates and Caps
For investors who have different beliefs about what future market returns will be, I mentioned how the different crediting methods could provide a benefit based on one’s expectations. But to the extent that knowing future market performance is not feasible, one does not need to worry too much about the complexity of various crediting methods. When FIAs are priced competitively, then one cannot easily predict in advance which crediting method will perform best. The choice of a crediting method should be based more on what we are comfortable using.
The annual reset one-year term point-to-point crediting method is relatively easy to understand and is commonly used with FIAs offering lifetime income benefits. Being common, it also has a better opportunity to be found with competitive pricing, as it can be hard to know whether other complex and uncommon crediting methods are offering reasonable pricing.
The key to FIA performance is not so much the crediting method, but the insurance company behind it and how it treats its customers. When resetting parameters at each term, does the company continue to price competitively or keep more for itself. Do they manage their expenses well in order to keep the most available for the options budget? Negative market movements could understandably result in a need to change parameter values in an adverse direction. But a good company will not take advantage of this fact as well as consumer inertia to create worse terms for the consumer upon term renewal.
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This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.