Does Your FIA Index Crediting Strategy Swing for the Fences?
December 4, 2015 by MIKE SCRIVER, BRENDAN SHEEHAN
Babe Ruth began his baseball career in Boston as a pitcher. In 1919, he switched to a field position in order to bat on a daily basis. He batted extremely well, leading the league in home runs and runs batted in, but it wasn’t until he joined the New York Yankees in 1920 that he became the home run hero he is known as today.
However, it’s important to understand that Ruth’s evolution to becoming a home run specialist for the Yankees came at a cost. In the season after he joined the Yankees, his home run tally rose from 29 to 54 — an 86 percent increase — but his strikeouts increased 48 percent, from 58 to 80. Like most things, there are risks and rewards in pursuing a new strategy. Put into investing terms, Boston Babe Ruth achieved steady low returns, while New York Babe Ruth achieved occasional high returns.Babe Ruth’s transformation from a steady hitter to an all-or-nothing slugger can be a useful analogy when considering how to think about the risk/reward trade-off found in fixed index annuity (FIA) crediting strategies. In an FIA, “Babe-like” performance is not ensured; different results may arise from different crediting strategies.
So, which strategy may be appropriate for your client? Ultimately, a good strategy for each client will vary based on their individual goals and objectives, and their tolerance for variable outcomes. Using this baseball analogy may be a useful way to approach the topic and make a more informed decision.
HOME RUNS VERSUS SINGLES — WHICH MAY BE APPROPRIATE FOR YOUR CLIENT?
Index crediting strategies with high averages are like New York Babe Ruth. They are more likely to have a few “home run” years, with the majority of the years’ performance below the average, or worse — a “strikeout” year with zero interest credit. By contrast, index crediting strategies with more conservative averages have performed more consistently, just as singles are more frequent than home runs.
The continuum of risk and reward with the various index crediting strategies for FIAs is illustrated nicely in the graphic below. Although looking to the past should not be used to predict the future, history can provide insights into the various characteristics of an index crediting strategy.
The different index crediting strategies available in FIAs are designed to give consumers a variety of options to manage volatility and choices among strategies for either steadier or more variable interest credits.
This historical analysis highlights some interesting patterns:
- Index crediting strategies that pay off the highest amount on average tend to fluctuate most often.
- High-average strategies are difficult to predict and can have larger swings than the more conservative strategies.
- The actual average for these high-average strategies is driven by the “home run” years; the interest credits in most years are less than the average.
The most volatile strategies can be identified by their higher zero interest credit frequency and higher potentials. The three most volatile strategies — monthly sum, annual point-to-point with a spread and monthly average — would have returned zero-percent credit more than half the time. This reflects the trade-off between performance and risk, the risk here being low or less-than-expected credited interest rather than actual loss of principal. In contrast, annual point-to-point with a cap offers a lower expected interest credit but would have provided at least some interest credit in more than two-thirds of the years.
Allocating to a fixed interest strategy, of course, would have eliminated the possibility of no interest credited but would have offered limited interest potential.
COACHING OPPORTUNITY: EXPLAINING THE BENEFITS OF A BALANCED APPROACH
Returning to our baseball analogy, some of the best baseball teams are made up of individuals with various strengths, where players can balance their strengths against the weaknesses of other players. Most teams try to create a balance, having players who consistently hit singles and doubles and have high batting averages along with power hitters who hit more home runs. Similarly, some types of interest crediting strategies emphasize higher returns but also pose a greater risk of a zero return; others may have steadier but lower likelihood of returns.
Creating a balanced index crediting team with equal weighting given to each of the four index crediting strategies is a way to help even out the potential for risk and reward, and could appeal to a broad segment of clients. The graphic above gives a visual sense of how the different strategies carry varying levels of risk and return.
Interest Credit Ratio = This ratio gives a measure of the expected interest credit compared with the chance of disappointment, i.e., no interest credit. A high ratio will indicate one of two things:
- The expected interest credit outweighs the corresponding risk of a low or zero interest credit, or
- The low risk offsets the lower expected interest credit.
Looking historically, the mixed allocation strategy would have offered something for almost everyone. For a low-risk-tolerance client, this strategy would have had a lower frequency of zero interest credits than a 100 percent allocation to any of the four crediting strategies. For the medium-risk-tolerance client, this strategy would have provided the highest interest crediting ratio. And for a highly risk-tolerant individual, it would have provided an increased average interest credit over monthly average and annual point-to-point with a cap.
The following graphic shows a completely hypothetical historical breakdown of the performance of the mixed allocation strategy, highlighting elements of both the single and home run strategies.
Some people prefer their interest crediting to be all-or-nothing, like the Yankees Babe Ruth. Others prefer their interest crediting to be less exciting and more consistent, like the Red Sox Babe Ruth. The key is identifying your clients’ preferences and then working together to choose their strategies accordingly.
Although not a guarantee of performance, balancing exposure to a variety of index crediting strategies may be a winning approach for your clients because it may help avoid a full allocation to the worst-performing strategy, while likely maintaining some exposure to the better- or best-performing strategies each year.
As a financial professional — the coach in this scenario — you have a tremendous opportunity to deliver value to your clients by understanding the different index crediting strategies available in FIAs and providing guidance on what may be the most effective strategy for their retirement income goals. Whatever your clients’ specific needs and tolerance for zero interest credits may be, the differing index crediting strategies are designed to provide a variety of options so you and your clients can create a solid team.
Originally Posted at InsuranceNewsNet Magazine on December 2015 by MIKE SCRIVER, BRENDAN SHEEHAN.
Categories: Industry Articles
