Index Annuity Returns Backwards & Forward

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The average annualized index annuity returns collected by Advantage Compendium for the period 2007 to 2012 averaged 3.27%. Whether this was good or bad depended on where else you might have been. Compared to rolling over one-year certificates of deposit, owning an index fund or owning the average stock fund, the average index annuity return looked pretty good. However, compared to a five-year CD you might have purchased back in 2007, the index annuity return was maybe a percent short, and many bonds and bond funds also beat the average index annuity for the period.

As five-year periods go, the most recent one had the lowest returns so far recorded, but it also shows the attractiveness of the concept. This last period included the mortgage bond crisis, the crash of ’08, a severe recession and a sluggish recovery. The S&P 500 index itself finished lower than where it began, but in spite of all this, the index annuities produced returns that ranged from 1.2% to 5.5% a year.

The competitive environment for index annuities over the next five years is more positive mainly, because alternatives are more negative. The reality is low interest rates will keep caps and overall index participation low for most of the period. So, which crediting method is best going forward?


Caps index annuity methods don’t average – annual point-to-point or APP – and today range from two percent to four percent. If you look back at the S&P 500 historically, you see the five-year periods typically posted gains in three or four of the five years. What this means is that at a two percent cap translates into a five-year annualized return of 1.2% or 1.6% and a four percent cap means 2.4% or 3.2% overall yearly returns. If you look at crediting methods using averaging, you get historic average annual returns of around 1.8% with a three percent cap and around 3.2% with a five percent cap.

Looking at the most often used crediting methods, assuming the caps don’t change and the stock market repeats past broad patterns, the index annuity delivers annual returns in the low ones to as much as three percent; returns that don’t get the heart racing, but are still more than competitive with current one-year or five-year certificate of deposit rates. How would other crediting methods perform?

Monthly Cap

A monthly cap crediting method is one that computes the index gain or loss for each month of the year and tallies up the losses (without limit) and the gains (with limits) to produce a yearly sum. Historically speaking, a two percent monthly cap produces, on average, a two percent annualized interest rate over five-year periods and a 2.5% monthly cap creates a 2.9% 5-year yield, but averages are misleading. Monthly caps have much greater swings than other cap methods. In these examples, there’s a far greater likelihood that you could wind up earning 0.6% or even less, but because of the swings, there’s still a shot at earning annualized yields of four percent or more. Monthly caps increase the chance of both higher and lower returns, compared to the previously named methods.


Term end point designs measure index movement over a three-year or longer time frame. They are able to offer greater index participation, because the cost of hedging the index-link is lower. Balanced annuities offer a blended potential yield based on the return of a fixed rate and an uncapped percentage of index movement. Both types of methods offer the potential for higher returns, compared to the capped methods – if the index cooperates.

Hypothetically and historically, the annualized return over five years is:

  • A 2% APP Cap is 1.2% or 1.6% annualized
  • A 3% APP Cap is 1.8% or 2.3% annualized
  • A 4% APP Cap is 2.4% or 3.2% annualized
  • A 3% Averaging Cap is 1.8% annualized
  • A 5% Averaging Cap is 3.2% annualized
  • Averaging with an 8% Yield Spread is 2.5% annualized
  • A 2% Monthly Cap averages 2% and a 2.5% Monthly Cap averages 2.9%, but with much greater swings than other methods.
  • Blended & Term End Point methods offer more interest potential – in a bullish stock market environment
  • A rising interest rate environment means more money is available for index participation and it doesn’t take much of a bump to get back to 6% caps

Different Indices

Stock markets have become more correlated and tend to move in the same directions and with similar magnitudes. Because of this, the decision should be based more on the height of the cap rather than the one you imagine will be the best performing index. In other words, an annual-point-to-point cap of five percent is better than one of three percent, regardless of the indexes involved, because the performance of the two indices will probably be much worse or much better than the two percent difference in capped returns.

What about non-stock indices? If the potential return on the non-stock index is higher then the answer is, why not select the non-stock index? It makes sense to be aggressive in these low cap times, because the opportunity cost of being wrong is so low.

Index Participation will Increase

These one percent to three percent yields being talked about, assume index annuity participation doesn’t get better, but it most likely will. Although there is downward pressure on interest rates until 2015, I wouldn’t be surprised to see caps and rates increase before then, as carriers realize the future may not be as bleak as it looks today. It simply doesn’t take much of a boost in bond yields to get caps back to five percent, six percent or even seven percent. Even in this low cap world, index annuities are still very competitive when compared with CDs and fixed rate annuities.

All return information is hypothetical and doesn’t provide investment or tax advice. Information is from sources believed accurate but is not warranted. Past performance is not guaranteed. “S&P 500” is a trademark of The McGraw-Hill Companies, Inc., which doesn’t sponsor, promote or endorse any index annuity.


Jack Marrion is president of Advantage Compendium Ltd providing research and consulting services to select financial companies. He has twice been asked to address the National Association of Insurance Commissioners on annuity issues, his insights on the annuity and retirement income world have appeared in hundreds of publications including Business Week, Kiplinger and The Wall Street Journal, and his research is frequently referenced by regulators.

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