What Is the Annual Reset Method?

What Is the Annual Reset Method?

The annual reset method is one indexing method that insurers use to calculate the interest for an indexed annuity. Indexing methods measure the performance of an annuity’s underlying index and translates any growth in index value to gains in the annuity’s value.

“An annual reset simply means that you look at the index value at the end of the year in comparison to the beginning of the year,” Matt Lewis, a certified long-term care (CLTC) specialist and vice president of Insurance at Carson Group, told Annuity.org. “If the index is higher at the end, the account value is reset to the higher point.”

Each year, the index’s value becomes the new starting point for next year’s calculation, hence the name annual reset. This sets annual reset contracts apart from other designs, which typically only use the index’s value on the first day of the contract as a starting point.

The annual reset method also differs from other contract designs because it credits interest every year there is a gain, rather than only once at the end of the annuity’s term. As a result, the interest on annual reset annuities can have the chance to compound, especially if gains occur in the early years of the contract.

Annuities with the annual reset method offer contract holders the opportunity to earn positive returns even in underperforming years.

Marguerita M. Cheng, CFP®, CRPC®, CSRIC®, RICP®CEO of Blue Ocean Global Wealth

Marguerita M. Cheng, CFP®, CRPC®, CSRIC®, RICP®, is the chief executive officer at Blue Ocean Global Wealth. As a CFP Board of Standards Ambassador, Marguerita educates the public, policymakers and media about the benefits of competent and ethical financial planning. She is a past spokesperson for the AARP Financial Freedom campaign.

Annual Reset Method Example

The following chart illustrates the potential return an indexed annuity might generate using the annual reset method. This hypothetical assumes the annuity has a six-year term, a 100% participation rate and an 8% rate cap, meaning no more than 8% interest can be credited to the contract each year.  

Annual Reset Indexed Annuity

As seen above, the annual reset method can generate compounded returns while protecting the owner’s principal investment during the index’s down years.

The annual reset design even allows these contracts to benefit from down years. In the hypothetical scenario above, the index experiences a sharp downturn in year two and does not fully rebound by year three. Nevertheless, the annual reset annuity still registers the growth in year three without taking the hit from the previous year.

The chance to accumulate returns even in underperforming years sets the annual reset design apart from other interest-crediting methods. For this reason, annual reset contracts often come with hedging provisions, like rate caps or participation rates, which may reduce the potential returns of the contract. Lewis recommends comparing participation rates and caps across multiple products when evaluating indexed annuities.

Annuities with the annual reset design perform best in average markets or if there is a substantial decline in the underlying index’s value in the first few years of the contract’s term.

Pros and Cons of the Annual Reset Method

The annual reset method might seem like the best contract design for an indexed annuity, but each indexing method has benefits and drawbacks. 

The strengths of the annual reset design include the ability to benefit from down years and the compounding effect of crediting interest to the contract every year that the index shows a gain.

Because the annuity can begin accumulating growth after the first year, an annual reset contract might be particularly advantageous for contract owners who want to make withdrawals before the contract’s term elapses.

However, every contract design has disadvantages as well. The annual reset design presents the most risk to the insurer, so most insurers use limiting provisions so that owners don’t receive the entirety of the index’s gains. 

Additionally, the annual reset is perhaps the most complex contract design, and some customers may find it difficult to understand the details of the contract. Working with a financial advisor can ensure that you understand the index crediting method when you purchase an annuity with an annual reset design.