How Rates are Credited
Credited rate analysis in the industry is not an exact science. There are many factors considered when determining credited interest rates:
Methods of Crediting (Fixed) Annuity Interest
- The company’s net earnings rate expected (the gross earnings rate less investment expenses) on the portfolio of assets supporting the product;
- The net earnings rate on new money being invested in that portfolio of assets supporting the product;
- Credited rate methodology, i.e., new money vs. portfolio approach;
- The desired interest margin, which is the difference between the company’s net earnings rate and the credited interest rate, to support the product pricing;
- Actual vs. assumed experience of other factors, such as persistency, mortality, and expenses;
- Credited interest rates on other products within the company and by the competition;
- Whether the current interest rate is indexed or declared, and how often it’s subject to change;
- The “floor” guaranteed interest rate on the product;
- The products’ loading structure (front-load vs. back-end load);
- The level of risk associated with the product: investment risks, pricing assumptions, adverse deviation risks, (when prices soar due to unpredictable adversities such as an epidemic or severe inflation) and business risks.
Insurance companies have numerous ways to invest fixed annuity funds and credit interest to their contracts. It's important to emphasize that every such contract contains a guaranteed minimum rate. This provision has always been the backbone of the annuity product and means that the owner's principal is not at risk. Minimum annuity interest rates reflect, in part, the reserving and nonforfeiture requirements that insurers must meet. In effect, the minimum interest rate provides a guaranteed worst-case scenario relative to a fixed contract's growth. For most fixed annuities, the minimum rate is 2% to 3%.
With some product designs, the minimum rate has little meaning. The certificate annuity ('CD-type annuity'), for example, always guarantees the current interest rate through the end of the surrender charge period. In such a case, the minimum interest rate has little bearing on the contract from the contractholder's perspective. With other product designs, notably equity indexed annuities, the minimum guaranteed rate may be applied to less than 100% of the contract's principal for the first few years.New Money Rate
A new money
method of crediting interest is sometimes referred to as pocket
investing. In managing the new money interest rate, the insurer places the annuity premium deposits during any given interest rate cycle into a pocket or bucket. Monies are directed into the same bucket as long as interest rates remain relatively stable. In a period of widely fluctuating interest rates, an insurer may open and close a bucket in as short a period as one week. Once these buckets have been established, the insurer evaluates each of them at renewal time to establish the renewal rate. The insurer looks at the cash flows from the underlying investments, reinvestment of the undistributed cash flows and the market value of the investment portfolio, as well as many other factors, before arriving at a renewal rate.
It is important to understand that the declared renewal rate applies only to those contracts issued during the time the bucket was open. This means that each contractholder, in essence, buys into a limited portfolio of investments available at that particular time. This is contrary to the portfolio rate method of investing.
A new money method is the most difficult way to credit and administer annuity interest. A year of heavily fluctuating interest rates results in the creation of numerous buckets. So why do insurers use this method? Most experts agree that it is the fairest way to treat contractholders and the safest way for the insurer to manage their annuity business. Should interest rates move up or down dramatically, the buckets are in better position to react to those changes because of their structure.Portfolio Rates
By contrast, portfolio rate
interest crediting is simple to understand. All annuity monies go into one large pool or portfolio. The total return of that portfolio is used to establish the interest rate for all contracthilders who buy that annuity. When it comes to renewal time, the insurer looks at the entire portfolio, regardless of when each individual investor bought his or her contract, and assigns a renewal rate for the entire block.
Portfolio rate annuities also can use different methods of declaring interest rates. Most portfolio rate insurers simply apply one interest rate to all contractholders within a portfolio. A few insurers with portfolio rate annuities credit interest on a calendar-year basis. For example, let's say that Portfolio Life Insurance Company credits interest on a portfolio basis. Each year on January 15 the company sets the rate for the annuity block based on the entire portfolio. Regardless of when a contractholder deposits money with Portfolio Life, he or she earns the interest rate declared until the following January 15th. Most insurers have turned away from this method because of the obvious exposure to volatile interest rate movements.
Theoretically, portfolio rates are considered to be fair to contractholders because rates move up or down with equal probability, and old and new contractholders alike share in these changes. This theory is flawed, however. For example, in a falling rate environment, an insurer credits 6% to its contracts while comparable carriers credit 5%. This insurer then would either have all the business it wants or be able to achieve tremendous profits. The reverse is supposed to happen in the rising rate scenario, but it does not. This carrier now is forced to acquire new business at 6% when its competitors offer 7%. Actually, the first dollar of new business must be acquired at 5%, with competitors at 7%. This does not happen. To remain competitive, this carrier must close this portfolio and start anew. This means that old deposits never get the advantage of rising rates, but always get the disadvantage of falling rates.Indexed Rates
The final type of interest crediting is an indexed rate of return
. Indexed annuities became very popular in the late 1990s and remain so today. Two variations exist: indexed interest and indexed equity rates.Indexed Interest Rates
The first indexed rate annuity was introduced in 1981. This particular annuity has a one-year interest rate guarantee, and subsequent annual renewal rates are based on a national independent bond index. By using an independent measure, the contractholder is guaranteed that the insurer has no influence over the index and therefore will credit a competitive rate relative to the market.Indexed Equity Rates
An equity index annuity has a credited ratio that is tied to a stock market index, such as the S&P 500 or Dow Jones Industrial. Like the interest index, the return is tied to an independent, outside measure that the insurer does not and cannot influence. This should result in fair renewal rates based on stock market performance.
Last Updated: 9/23/2012 10:05:00 PM