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New “uncapped” indexed interest strategies are becoming popular and prevalent; do you understand them?


The rise in the availability and promotion of uncapped strategies is a direct reflection of the low interest rate environment, as insurance companies strive to find innovative ways to offer the annuity owner a higher potential upside than can be achieved with “capped” strategies, and appeal to the consumer who has experienced a five-year “bull market.” Here are some key concepts of how these Hybrid Annuities with "uncapped" indexed interest strategies work.


First and foremost, let’s clarify a couple of important concepts. An “uncapped” strategy is not an “unlimited” strategy. It is actuarially impossible to offer a financial tool that will return 100% of the performance of a stock market index while at the same time fully protecting against market loss (well, it may be possible but the fees required to protect the insurance company, and therefore ultimately the policy owners, would make it impractical). Thus, all indexed interest strategies limit how much of the potential index performance that will be converted to credited interest; this can be accomplished by adjustments to the Participation Rate, the imposition of a Cap, the use of a Spread and/or a Fee, the imposition of a fixed interest rate allocation, or a combination of all these components (a detailed treatise of how the internal components of indexed interest strategies are actuarially designed and manipulated to achieve target interest crediting is a subject for another day).

For simplicity, let’s look at how the common ways potential interest earnings are limited:

A Cap: A “Cap” sets a “hard limit” to potential interest earnings. Regardless of the level of Index return, interest crediting cannot exceed the Cap. For example, a 5% Cap applied to a 10% Index return would credit 5% interest; if the Index returns 20%, the credited interest would still be 5% (this of course assumes a 100% Participation Rate).

A Participation Rate: A “stand-alone” Participation Rate (less than 100%) sets a “soft limit” to potential interest earnings. For example, a 50% Participation Rate applied to a 10% Index return would credit 5% interest; if the Index returns 20%, the credited interest would be 10% .

A Spread: A Spread sets a “soft limit” to potential interest earnings. For example, a 5% Spread applied to a 10% Index return would credit 5% interest; if the Index returns 20%, the credited interest would be 15% (this of course assumes a 100% Participation Rate).

Thus, indexed interest strategies that use either a Spread or a “stand-alone” Participation Rate are considered “uncapped” strategies because they don’t impose a “hard limit” by the use of Cap. So, while the Author is a fan of “uncapped” strategies, it is important to realize that they too are still limited in regard to the percent of the Index gain that will be credited as interest, and it is critically important that your client also understand this. By the way, “uncapped” indexed interest strategies are not new, in fact they were the original form of indexed interest strategy. When Fixed Indexed Annuities were first developed in the mid-1990’s, the first products used neither Caps nor Spreads; they limited potential interest earnings by the level of a “stand-alone” Participation Rate (these designs still exist).





The Big Question – Which is best?


It depends upon what the market does. Any type of indexed interest strategy may out-perform another type in a given market environment over the short-term, and we only know that in hindsight:

For example, let’s say the Index returns only 5%; the 5% Cap would credit 5%, the 50% “stand-alone” Participation Rate would credit 2.5%, and the 5% Spread would credit 0%.

This is why Fixed Indexed Annuities are not intended to be competitive with securities; they are first and foremost risk management tools to protect against downside loss and provide retirement income. Nonetheless, we can use some general guidance to help the annuity professional both evaluate the potential performance of both capped and uncapped indexed interest strategies.


Evaluating the Potential of an Uncapped Strategy


Start with the Linked Index. The first element of evaluating the potential of an uncapped strategy is to examine the Index to which it is linked. Many uncapped strategies, either Spread-based or Participation Rate-based, are linked to the commonly-understood broad market indexes such as the S&P 500 Composite Stock Price Index, the Dow Jones Industrial Average, or the NASDAQ Composite Index. The advantage of linking to these broad indexes is simply that most consumers have heard of them, and their performance history is widely available and easily tracked.

Increasingly, we’ve seen strategies that are linked to less well-known indexes, or in some cases, indexes that are created by the insurance carrier. This Author recommends avoiding indexes that are created by the insurance carrier, as it can be difficult, if not impossible, to track their performance through public sources; fortunately, this is not common amongst carriers. Indexes that are linked to less well-known – but publicly reported- indexes, however, can offer good potential crediting, depending of course upon the structure of the Index.

Actively Managed Indexes “Actively-managed” means that investment professionals are routinely reallocating the index amongst the asset classes with the goal of achieving positive returns in an environment where “passive” indexes (such as the S&P 500) struggle to achieve gains. For example, there is an uncapped strategy available (Spread-based) that is linked to an actively-managed Index that consists of non-correlated assets such as domestic and global equities, bonds, commodities, gold, and cash (money market and currency). This type of Index offers good potential for gain so long as the Spread seems reasonable in relation to the historical return.

Volatility-Controlled Indexes This is a type of actively-managed index that seeks to control extreme swings in performance (volatility). While there can be an advantage to this, bear in mind that “volatility control” swings both ways – in order to control or limit downward volatility (losses), it also requires controlling or limiting upward volatility (gains). Thus, an attractively low Spread (or high stand-alone Participation Rate) when applied to an Index that is managed to achieve relatively low returns may not be as attractive as it first appears. If the index history is public, it is a simple process to research historical results and apply the Spread or Participation Rate to that history.

Finally on the subject of the linked Index, some annuities offer uncapped strategies linked to non-equity Indexes. These can be commodities, bonds, gold, real estate, etc. In some scenarios these non-equity indexes may perform quite well, in other scenarios perhaps not, but this is of course equally true of equity indexes. Once again, it depends upon what the market does.





In closing, we return to the basics: guaranteed annuities are first and foremost risk management tools to protect against downside loss and provide retirement income. Within that base context of safety and income guarantees, many uncapped strategies do offer greater potential crediting to the annuity Contract Value, and thus can provide an additional and important benefit to the client.



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