The Indexed Approach

For several decades insurance companies have been using an approach to determining credited interest rate that is known as indexing.  It’s a practice that has had it’s detractors (yours truly for a little while) and has been a method that has been used for good an evil by well educated and unscrupulous agents respectively.  Today we’re going to dive into what it is, what it’s not, and ask if it works (i.e. is it worth your time).

How Does it Work?

Indexing as a process of using the percent change of an index to determine an interest rate to credit to a fixed insurance product (for example the S&P 500).  There are a few different “strategies” used to perform the indexing.  The most popular (and probably the only one worth spending any time learning) is called point-to-point.  This method take the closing value of an index on a beginning date and on an ending date and calculates the percent change in the index.  The percent change is then the interest rate credited to the cash in the policy for a given period.

So for example, an annual point-to-point indexing of the S&P 500 would take the closing value of the S&P on the first trading day of the year and the closing value on the last trading day of the year and calculate the percent change.  This percentage would then be the interest credited to the cash in the insurance policy.

Caps and Participation?

Indexed products also have provisions known as participation rates and rate caps.  Participation rates are quoted as a percentage of the amount of the indexed change you’ll actually get (participate in).  So a 75% participation rate would mean if the percent change in an index was 10%, the actual interest credited would be 7.5% and a 100% participation rate means 10% would be credited.  Cap rates are a cap to the maximum allowable interest rate.  So a 12% cap would mean if the percent change was 15%, you’re going to get 12% because you are not allowed a higher rate on the contract.

Intuitively it makes sense to look at contracts that have a 100% participation rate and as high a cap rate as possible.  However, there may be room to give a little on one in exchange for more on the other.  And, it may be prudent to find a contract that guarantees some of these provisions (i.e. a guaranteed 100% participation rate, meaning it never changes).

 That’s It…Really

That, in a nut shell, is really it when it comes to indexing.  A lot like Calculus, the actually Calculus part is pretty small, it’s the the mix of somewhat complicated algebra and elements of trig that make it seem complicated.  But this would all be slightly remiss if we didn’t dig a little deeper and point out a few additional points.

The Indexing Strategy Matters

While some companies make it really simple, others don’t.  A lot like disability insurance, less is more when it comes to contract language in an indexed product.  Annual point-to-point is the strategy of choice.  Some insurance companies will attract agents and clients to more complicated methods that traditionally perform worse by dangling out a higher cap (and some even go so far as to default assumed interest rate higher on some of those more complicated methods) but let math and historical evidence be your friend, annual point-to-point (sometimes shortened to pt-2-pt) has won in most all scenarios.

Contract Specifics are Important

It’s not really the indexing that is complicated, it’s all of the other provisions insurance companies sometimes put into these contracts.  This is were a little prudence is necessary.  This isn’t unique to indexed products.  There are plenty of other life and annuity products that have strange elements that are sometimes a little hidden in the contract language.  Like the way policy loans effect crediting or dividend interest rates, or how market value adjustments are used on a fixed annuity, or how a variable annuity might use a value algorithm to automatically adjust your investments into fixed accounts when the account balance starts to fall due to a declining market.  It’s not the product heading that is tricky, it’s the company particulars.

What It’s Not

Indexing is not an investment in the stock market.  It’s not a way to get into the market.  It’s not a way to get the upside potential of the market without the down side risk.  It is true that indexing will not go backwards (it’s contractually designed not to do that), meaning there’s a minimum set that is never negative (usually 0 but sometimes 1 or 2 percent).  This means even if the index posts a negative return for the indexing period, there is money deducted to match this negative percent change.  But it’s simply a method for establishing an interest rate paid on your money.  There is no market exposure, and it should not be thought of as an alternative to stocks in terms of being a similar asset class.  Instead it’s an alternative that is a very different asset class, just as bonds are a very different asset class.

Does it Work?

In short, yes.  The exact evidence of which we will roll out in a day or two.  So to recap.  Annual point-two-point is the strategy of choice.  What participation rates and cap rate.  And understand that you are in no way getting into the stock market by virtue of putting your money in an indexed product.  And stay tuned for a post coming later this week to analyze the expected value of using an indexed product.


One Response to “The Indexed Approach”

  1. [...] that we know the basics of indexing, we can dive into a much more interesting topic: Does it work?  We’re going to use a [...]

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