Commonly Used Annuity Indexing Methods
Below are BRIEF explanations of the four most commonly used indexing methods for Equity-Linked Annuities. These methods may or may include an example. All examples are hypothetical and used for illustrative purposes only.
Annual Reset Method
The annual reset method indexes your gains annually (on your policy anniversary date) and locks them in permanently. For example, let's say the S&P 500 rose 14% over your anniversary period and your index participation rate is 85%. You would receive 11.9% credited to your account and that gain would be locked in forever.
High Water Mark Method
The high water mark method uses a two-point method, whereby the starting point is the policy's inception date and the ending point is the anniversary date.
For example, let's say the S&P 500 index upon the policy inception date was at 1000. One year later the S&P stood at 1200. That represents a 20% hypothetical gain. You take this gain and multiply by the participation rate and that gives you your return for that year.
The 1200 now become your new high water mark which in the mark that must be exceeded in the following years to realize future gains. If your participation rate was 100% of the S&P 500 and the S&P stayed at 1200 and for the next 6 years, as an example, you'd take that 20% gain amortized over 7 years. Then you'd end up only having a 2.8% average annual return. What the likelihood of this? Well, possible, but not probable.
On the other hand, let's say the S&P grew to 2600 by the end of the 7th contract year. That would represent 160% overall gain or 22.85% average annual return.
Point to Point Method
The point to point method of indexing also looks at two periods, except these are the beginning point and ending point of the contract (usually 5-7 years).
For example, let's say the starting point was 1000 on the S&P 500 in year one and by contract end the S&P stood at 2000. This represents a 100% gain over said period. Your participation rate is then multiplied by this gain and credited to your account.
This method averages your return over the course of each anniversary period based on each day's closing price of, say, the S&P 500 Index (typically 250 trading days).
The idea behind averaging is to defuse the risk of rolling market performance. However, if the market goes straight up, an averaging method will reduce your overall gains.
Each method has its advantages and disadvantages.
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