Indexing Methods for Indexed Annuities

What Are Indexing Methods?

Indexed annuities, also known as fixed indexed annuities, accumulate growth according to the performance of a market index. However, the growth of an indexed annuity does not directly reflect index performance. Instead, annuity providers use different indexing methods, sometimes called crediting methods, to measure the index’s growth so they can credit interest to the contract. 

As Elle Switzer, director of Annuity Product Management at TruStage, told Annuity.org, indexing methods typically have two components. 

“The first component of the interest crediting method is the time performance [it] is measured over,” said Switzer. “For example, in the one-year point-to-point method, you would compare the index value at the end of the one-year period to the index value at the start of the one-year period to determine the index return.”

The other factor that goes into interest calculations is what Switzer called “the upside potential parameter.” Indexed annuities typically come with measures to limit how much growth from the index is credited to the contract, such as a participation rate, rate cap or rate spread. Insurers use these provisions to mitigate the risk they take on when issuing an indexed annuity contract. 

Types of Indexing Methods

Insurers may offer a variety of crediting options for an indexed annuity contract, but generally, they fall into three categories: annual reset, point-to-point and high-water mark.

Each of these indexing methods can benefit an indexed annuity owner by protecting the annuity’s value from market volatility while participating in the growth of an index. Together, these features make indexed annuities a potentially advantageous resource for maintaining your retirement lifestyle.

Annual Reset Method

The annual reset method measures the performance of the underlying index each year. On the contract’s anniversary date, the insurer compares the index’s current value to its value on the previous anniversary date.

If the index performs well, a percentage of that growth is credited to the annuity’s contract. If the index has declined, the contract does not lose value, but will not be credited any interest besides the guaranteed minimum rate.

Indexed annuities with the annual reset method credit interest each year, a feature unique to this contract design. This allows gains to compound each year that the index has a gain. For this reason, annual reset contracts tend to outperform other indexing methods if there is a substantial loss in index value during the first years of the contract’s term.

Point-to-Point

The point-to-point method provides the most straightforward way to calculate interest on an indexed annuity. With this method, the insurer simply looks at the beginning value of the index and the value on the last day of the contract’s term. Any gain in the index’s value represents the annuity’s return, once provisions like participation rate or rate cap are applied.

Point-to-point contracts present less risk to the insurer, so these contracts might have other features that make them more beneficial to the annuity owner. For example, an indexed annuity with the point-to-point method might have a higher participation rate than an annual reset contract.

However, this also means that the point-to-point design carries more risk for the annuity owner. Because the starting value and ending value are the only variables that factor into the calculation, any gains the index might have made over the contract’s term could be lost if the index declines in the final months or weeks of the term.

High-Water Mark

The high-water mark design is similar to the point-to-point method. However, instead of comparing the beginning and ending index values, the high-water mark method subtracts the beginning index value from the index’s highest value on an anniversary date over the contract’s term.

By using the highest anniversary value, the high-water mark design eliminates the risk of a late-term downturn wiping out previous index gains. This makes the high-water mark design perform well in a volatile market, as it can capitalize on the index’s highest highs while disregarding the lows.

Like point-to-point, interest on a high-water mark annuity is not credited until the end of the contract’s term. This could be a disadvantage if you have concerns about the liquidity of your annuity; if you decide to withdraw early, you won’t receive any gains from the index’s growth.

Comparing Indexing Methods

To better understand how an annuity’s indexing method affects its returns, let’s look at a scenario that compares the three most popular designs. The following table shows the hypothetical performance of the S&P 500, assuming a 100.00 starting point.

The chart shows how an annuity tied to the S&P 500 would credit interest based on the three contract design types. For simplicity, this chart assumes that the contracts all have a 100% participation rate, no cap rate and no averaging.

Indexing Method Comparison

As this data shows, each contract design results in a different amount of interest credited to the annuity, despite having the same index performance throughout the contract’s term. The annual reset method accumulates a total of 62.8% growth as it compounds throughout the contract term.

The point-to-point contract ends up with no gains at all because the index’s value at the end of year five is lower than the starting value. In this case, the indexed annuity will likely only receive the minimum guaranteed rate, which typically comes out to 3% interest on 90% of the initial premium amount.

The total gain on the high-water mark contract comes out to 16.11%. The insurer got this return by subtracting the starting value of 100.00 from the highest anniversary value of 116.11 in year two. 

The chart above represents just one hypothetical outcome of these contract designs and does not account for a variety of factors. The returns on each contract could be quite different in a different five-year term with a different term length or if a different index was chosen. These calculations also left out contract provisions like participation rates and rate caps, which can significantly limit the performance of more generous interest-crediting designs.

In short, one indexing method is not necessarily better than the others. When choosing an indexed annuity, it’s important to consider not only how index gains are measured, but also what other clauses the insurer places in the contract that could impact the annuity’s gains. Also consider your risk tolerance, as some indexing methods are more exposed to market downturns than others.