What Is Index Averaging?

What Is Index Averaging?

Index averaging refers to how an insurer might average an index’s values when calculating the return of an indexed annuity. Over 75% of all indexed annuities use some form of averaging, usually in conjunction with an indexing method such as annual reset, high-water mark or point-to-point.

Averaging affects indexed annuity contracts by limiting the possible gains, but also guaranteeing that interest won’t be credited based on the index’s lowest point. 

“The benefit of this could be to lower the impact of short-term market volatility,” Matt Lewis, a Certified Long-Term Care (CLTC) specialist and vice president of Insurance at Carson Group, told Annuity.org. However, Lewis also said that averaging can result in “lower returns than those methods that are directly linked to the index’s performance.”

Avoiding the risk of low performance is crucial to many indexed annuity investors who rely on these products for guaranteed income in retirement.

Averaging can take a variety of forms and can occur at different points in an annuity’s term. An annuity provider might average the value of the annuity’s underlying index daily, monthly, or at the beginning and end of the term. 

Insurers employ averaging when calculating index performance to reduce the risk to both themselves and the annuity owner. Contracts with averaging tend to be more generous than other crediting strategies; they may have a higher participation rate or higher rate cap than a contract that does not use averaging.

How Does Index Averaging Work With Different Contract Designs?

Index averaging affects annuity contracts in different ways depending on the contract design. Of the various interest crediting methods for indexed annuities, the most common are annual reset, point-to-point and high-water mark.

It is important to review the contract design and crediting method for your index annuity to ensure that interest earned will not be based on the underlying index’s lowest point.

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

The annual reset method credits interest to an indexed annuity contract every year that the underlying index shows a gain. Each year on the contract’s anniversary date, the index’s value is compared to its value on the previous anniversary date, and the difference (if positive) represents the interest that will be credited to the annuity.

One way an annuity provider might use averaging with the annual reset method is by taking an average of each month’s index values instead of the end value on the anniversary date. For example, let’s assume you purchased an indexed annuity on Dec. 31 and the index that day was valued at 500 points. 

The following table shows the returns of this hypothetical index for each month of your contract’s first year.

To calculate the index’s performance, the insurer would total all the monthly ending values and divide by 12, resulting in a final value of 525.75. The insurer then subtracts the starting value of 500 from the averaged value to get 25.75. Finally, they divide the difference (25.75) by the initial index value, resulting in a total gain of 5.15%.

If the insurer did not apply the averaging method, the total growth of the index from the beginning of the year to the end would have been 11%. This represents the downside of averaging with an annual reset contract; in a bull market, or a market where stock prices are rising, averaging results in lower gains.

Because averaging can reduce the gains of an annual reset contract, some insurers offset this effect with other contract provisions. An annual reset annuity with averaging might have a participation rate close to, or sometimes even greater than, 100%, and often these contracts do not have a rate cap.

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Point-to-Point

Interest on a point-to-point indexed annuity is credited at the end of the term. To measure the index’s performance, insurers subtract the starting value of the index from the end value of the index.

When point-to-point contracts use averaging, it usually means that the final index value will be the average of the index’s performance over the contract’s last year. Depending on how the index performed, this could be advantageous to the annuity owner. A significant risk of the point-to-point method is losing any gains in the last weeks of the contract. Averaging the last year’s performance might help mitigate this risk.

High-Water Mark

The high-water mark method is a variation of the point-to-point design. Instead of just comparing the starting index value to the value at the end of the term, the high-water mark usually looks at the difference between the starting value and the highest value of an index on the anniversary date of the contract.

Similar to point-to-point contracts, insurers might average the index’s performance at the end of the contract for high-water mark annuities. This is usually done by averaging the index value over the last 60 days of the contract.

Because of the way high-water mark contracts measure index performance, there is a chance that the averaging feature will not affect the performance of this type of annuity. Averaging would only affect the crediting of a high-water mark contract if the averaging results in a higher value for the last anniversary date than any previous anniversary date.

Editor Bianca Dagostino contributed to this article.