How point-to-point indexed strategy works.

How a point-to-point indexed strategy works on an FIA

Indexed annuity, sometimes referred to as fixed indexed annuities, or FIAs, provide the potential to earn higher returns than those offered by traditional fixed annuities but without risking principal to market losses.

They earn interest based on the movement of a market index, giving them the ability to grow higher in value than fixed annuities that charge a flat rate of interest. However, you are not actually invested in the market or in any index. The insurance company simply uses the index as a measuring stick for how much to credit to your contract.

Indexed annuities use a variety of market indices. Some contract will even offer you choices on what indices you want your contract to be based upon. The most common index used as a benchmark is the Standard & Poor’s 500 (S&P 500), which is a widely used index to measure the U.S. stock market. Other options include the Russell 2000, the Wilshire 5000 and a number of international market indices.

Insurers offer several formulas for crediting interest, often called strategies. The strategy(s) you choose can significantly impact how much interest is credited to your annuity. That’s why you should carefully consider your options.

Also keep in mind that no single crediting method is best in all situations. In some market conditions, one crediting method may result in more interest than others.

The basics of the point-to-point strategy
The most common strategy is a one-year, or annual, point-to-point strategy. Here’s how this type of strategy works:

On your contract anniversary, the insurance company compares the beginning index value to the ending value.

If the ending value is lower than the beginning value, the contract will credit zero interest; the annuity’s account value won’t decrease in value due to the decline in the index, but the contract will not earn interest for that period.

If the ending value is higher, the insurance company will calculate the percentage increase. That percentage will be the amount of interest credited to the annuity’s account value, subject to any cap or spread.

For example, say you purchased an indexed annuity with a contract start date of August 1, 2014. The annuity’s indexed crediting strategy uses an annual point-to-point based on the Standard & Poor’s 500 index, and the contract calls for a 6 percent cap on interest growth.

The beginning value of the S&P 500 on August 1, 2014, was 1929.80. The ending value one year later, the market close on July 31, 2015, was 2103.84. The index increased in value by 9 percent during the first year. Since the index growth exceeded the cap, the contract would credit the cap rate of 6 percent to the annuity’s account value. Therefore, if you deposited $100,000 in the annuity to start with, your contract value after the first year would be $106,000.

The second contract year would begin with the index value of 2103.84. On the second contract anniversary, the S&P 500 index closed at 2170.84. The index, therefore, increased just over 3 percent for the year. Since that amount is below the cap rate, the annuity would be credited with a 3 percent increase for the second year. Adding 3 percent growth to the $106,000 account value you started the second contract year with would result in an account value of $109,180.

A point-to-point strategy tends to be less sensitive to market volatility, but it also will typically provide less interest growth potential than other strategies.

Another common type of point-to-point strategy is a biennial, or two-year, point-to-point. This works similarly to an annual point-to-point, except that it measures the index growth over a two-year period. So in the above example, the insurance company would measure the S&P 500 growth starting on August 1, 2014, and ending on August 1, 2016.

An explanation of caps and spreads
Because indexed annuities do not lose principal, there has to be a limit on their upside. As an indexed annuity holder, you’re essentially trading unlimited interest rate growth for the protection against negative returns.

Insurers have two methods of limiting an indexed annuity’s upside: caps and spreads.

A cap is a ceiling on interest rate growth. A typical cap might be 8 percent. That means your annuity’s account value can not increase more than 8 percent in any one period, regardless of how much the benchmark index increases. If the index increases 5 percent, your account value will increase 5 percent. If the index climbs 12 percent, the account value will be limited to 8 percent.

A spread, on the other hand, acts more like a floor. If your annuity has a 5 percent spread, your account value will increase by whatever percentage above 5 percent the corresponding index goes up. If the index increases 7 percent, your account value will grow 2 percent (7 – 5). If the index climbs 15 percent, your account value will earn 10 percent. But if the index only increases 3 percent, your account value will earn nothing for that period.