Index Interest 101: Understanding How it Works

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Index interest is a broad term I started using a few years ago to describe a class of assets that had a wide variety of names, but all functioned in the same manner. I don’t know if I was the first to use it when talking about these types of investments, but it fits and accurately describes what they are designed to do.

Index interest is a very simple concept. It is so simple that many people tend to over complicate it and then fail to understand how powerful a tool it can truly become. However, most investors are not even familiar with the investments that use index interest and many that are don’t fully understand how it could and should be used in constructing investment portfolios. With that in mind, let’s start with some basic ideas to establish a foundation we can build upon.

Most people are familiar with the concept of index interest and don’t even realize they are. Consumers have participated in index interest products for decades in the form of floating rate or adjustable rate loans. The most common way these loans work is how the interest that a borrower pays on a loan is linked to the “prime rate”. If prime goes up, the borrower pays more interest, if it goes down they pay less. These loans will many times have a ceiling rate so that if rates go up, at least the borrower will have a maximum amount they know they will pay. Even if rates drop to 0% the borrower still has a minimum rate that they pay, which is so many percent above the prime rate. Regardless of which way prime goes, the bank is still making money by charging a couple of percentage points or more above the prime rate. This is a case of index interest working primarily in the banks favor. The bank has effectively removed their interest rate risk and transferred it to the borrower. The borrower has taken on this risk in exchange for a lower interest rate and a lower payment than what they would have under a traditional fixed rate loan. The bank now has much less risk and a built in guaranteed profit, all in exchange for only a slightly smaller profit. So who is getting the better deal in this situation? Most of us would agree the bank is.

Now imagine yourself as the banker instead of the borrower. This is the “a-ha” moment for most people. Because when you view things from the banker’s perspective, using index interest now benefits you by transferring your interest rate risk to the borrower and allowing you to profit regardless of what happens to prevailing rates. This is the ideal scenario for making profits or “gains” from money loaned or “invested” year in and year out.

Now, what if we applied that same thinking to our own investing strategy? What if we were able to take the investments that could potentially cause us losses and transfer that risk over to someone else who would willingly assume the risk, all in exchange for us simply receiving a slightly smaller but more certain profit or gain? That is the question that launched the development of the investments known today as index CDs, market linked CDs, fixed-indexed annuities, indexed life insurance, structured notes, structured CDs and an array of other names that I refer to as index interest products.

The basic concept behind all index interest products is to take a traditional fixed interest product like a CD, fixed annuity or bond and rather than it paying a set declared rate of interest as it normally would, have it instead pay interest to the investor based on the performance of a separate asset or index.

If the index or separate asset performs favorably, the investor can earn much more than what they would if they had invested in the same type of product paying the traditional fixed rate, but not quite as much as if they had invested directly into the underlying index or asset. If instead the index or asset the interest is linked to performs unfavorably, the investor loses nothing and may even receive a small return, though not as much as they would have made investing in the same product with a declared rate. So it comes down to a trade off. The investor doesn’t make as much as they might have if the asset or index does well, but they take none of the losses if it does poorly. Or to put it another way, you give up some of the upside to have limited or no downside on a given index or asset. We have basically traded away most or all of the risk in exchange for a portion of the potential gains.

Let’s look at a simple example of this principle, just to reinforce the concept of index interest. Let’s say someone wants to invest in the stock market, but not into any particular individual stocks. A good way to accomplish this would be to invest into a fund that copies a well known stock market index like the S&P 500. Due to the nature of the stock market, the investor has the theoretical potential for unlimited gains and the theoretical potential for losses of up to 100% of the amount invested.

In reality, though the overall stock market would probably never go to zero, outside of a total collapse of the U.S. Government and the world economy, in which case no currency denominated investment is worth anything. Also the stock market, and therefore the index measuring will probably never triple or increase by 1,000% over the course of a year. We know, historically, that increases or decreases in the stock market over a one year period of more than 40% are rare. So, let’s assume the investor putting money into the index fund has the potential for a 40% gain or a 40% loss in any given year. Meaning, a $100 investment could be worth $140 (40% gain) or $60 (40% loss) over a one-year period.

Now contrast this with an index interest product linked to the same stock market index, the S&P 500, in which the investor has principle protection and gets only 75% of the upside of the market index. The investor’s range of returns now changes to between 0% and 30% (75% of 40%). Using the same $100 investment and one-year period, it could now be worth either $100 or $130. Thinking as a rational and logical investor, and given the choice between one account with a range of returns between -40% and +40% and another account with a range of returns between 0% and + 30%, which one would you choose? Most of us would go with the second account (0% to +30%) if we wanted to have consistent gains. And isn’t that the goal of investing money?

What if you client could profit from the good market years and not take losses in the bad years? Imagine the stabilizing effect this would have on a typical portfolio allocated between the different asset classes as outlined by modern portfolio theory. What if you took some of these more volatile classes like commodities, stocks, foreign currencies and emerging markets and eliminated the chance of loss from investing in them? This is exactly what using index interest has to offer to investors.


J.R. Thacker is President and Founder of Thacker & Associates Inc. and President of Center Street Securities, Inc. He has worked in the financial services industry since 1996. Thacker founded his own firm specializing in retirement planning. His unique approach to retirement investing quickly became popular, and the firm was voted “Best Financial Planner” for six years in a row. He can be reached by e-mail at info@indexinterest.com or jrthacker@thackerandassociates.com.

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