ANNUITY
Capped And Uncapped Annuity Strategies: Weighing The Options Each of these strategies provides accumulation potential while usually allowing for flexibility and reallocation opportunities.
accumulation potential while usually allowing for flexibility and reallocation opportunities on an annual or every other year basis.
By Doug Wolff
Explain Capped Vs. Uncapped
W
ith the widespread availability of COVID-19 vaccines in the U.S., many investors are hopeful. But even as savers nationwide continue to gain confidence amid the continuously fluctuating market, how are they addressing fast-moving market volatility? Some strategies have weathered these volatile markets and eased client anxieties of sudden or unsuspected losses. In particular, fixed indexed annuities have offered many retirement savers stable tax-deferred opportunities with the potential for solid accumulation. Many FIAs offer savers the ability to choose between capped and uncapped index strategies, with each providing
With contracts flooring at zero percent, FIAs give clients solid protection from market loss, along with the potential for accumulation. But can clients be sure FIAs are a viable option for building their savings while maintaining a comfortable level of risk? Advisors must educate clients on the range of FIA options available and ways in which they can take advantage of them. To guarantee principal in contracts, issuers design options on interest credits through a combination of a variety of account parameters including caps, participation rates and spreads. These parameters include uncapped and capped options. Allocating funds between both options is often a preferred strategy among many advisors and their clients. A cap is essentially the maximum
30%
Annualized 20 YR
20%
-10% -20%
5.56%
5.37%
S&P 500 Raw Index Return S&P 500 P2P Credit
4.54% 20
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18
15 13
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06 07
03 04 05
01
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10% 0%
interest rate your client can earn during the particular index term, regardless of the change in the underlying index. For example, if the cap is 5% and the value of the chosen underlying index rises by 10% during the index term, the cap amount of 5% will be credited to your client’s contract. However, if the index rises only 2%, the contract would only be credited 2%, as that is lower than the cap. Index crediting methodologies are established using what is commonly called a hedge budget. The hedge budget is set based on the amount the insurance company can earn on its investments less a net interest margin to cover expenses and profit. In this historically low interest rate environment, hedge budgets have been squeezed. Uncapped strategies typically involve a volatility control mechanism with the target volatility set at a relatively low level (as compared with the volatility of a typical equity index). This lowers the cost of the derivative used to back the index credits and allows the insurance company
3.30%
S&P Low Vol Raw Index Return S&P Low Vol P2P Credit
-30% Depending on the underlying index, different cap strategies will deliver different outcomes. The above example shows returns for the S&P 500 Price Index with a 5% cap1 and the uncapped S&P 500 Low Volatility 5% Index with a 1.5% spread.2 In both cases, a point-to-point crediting strategy (interest is the ending value less the starting value) is used, and the raw index returns are included for comparison. While the raw indexes produced higher average annual returns over time, they also experienced much bigger swings (i.e., volatility). The uncapped index featured solid performance over time but trailed the capped index in some years. The capped index trailed the raw index performance but delivered much smoother returns. In down years, both strategies credited zero, as principal is guaranteed against market loss. The 5% cap on the S&P 500 Price Index is an example; the actual cap would depend on many factors, including interest rates, hedge budgets, implied or actual volatility, other product features and expenses, and more. The cap is the maximum amount credited to the account value in that year. 1
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InsuranceNewsNet Magazine » November 2021
The 1.50% spread on the S&P 500 Low Volatility 5% Index is an example; the actual spread on the S&P Low Volatility 5% Index would depend on many factors, including interest rates, hedge budgets, other product features and expenses, and more. Each year, the spread is subtracted from the index performance, resulting in the amount credited to the account value (subject to a minimum of zero). 2
