I am considering a fixed S&P indexed Annuity that has monthly averaging. The monthly changes have an upper cap but negative changes are not limited. I believe this is typical of this type of annuity. My question is: Am I right in thinking that even though the S&P might increase in value over the course of a year there could be a situation whereby it could have a negative sum of capped values and thereby produce no income?

Conversely if the S&P had even a small loss over the course of a year there is no way that the sum of monthly averaging could end up on the plus side?


Yes. The problem with this type of crediting has to do with the volatility of the S&P from month to month. Even in a year where the S&P is up a tremendous amount, say 20%, there will be months that had a large gain, maybe four or 5%. Those gains are capped but then the losses will cancel out much of the gains and the result will be very disappointing.

It's not very difficult to go to a source of data, like Yahoo or Google, and pull down monthly numbers for the S&P 500. You can then apply this formula within a spreadsheet to see the impact, I will return tonight or tomorrow and update with the results. I have received this question in real life and number of times and my response has always been, "have you asked the salesman for an example of how this would've performed during any time?" Of course the answer was no. Why would that be? He'd have the opportunity to show the result in good year vs bad. "you lose nothing in these crash years." But (as I edited below) you gain so little in the up years, the product should be viewed as a scam. Only it's legal.

You give up so much of the upside over the years in exchange for not losing any money in one year that you would literally have been better off in short term treasuries.

This is one of the few products that's actually worse than a variable annuity or a whole life insurance policy.

Last, because these products are sold by an insurance salesman and not as a regular product like stocks or bonds, the regulation is different. It is difficult if not impossible to find the prospectus for these online. And when I've gone head to head with somebody online, they told me it was illegal for them to send me a prospectus as they were in a different state. How absurd is that?

Edit - I would like to add just 2 years' observations.

  1. The index was up 23.5%. (more with dividends, I'll ignore that) The return on an IA, given the 2% monthly cap formula, was 0%. Yes, 0. The multiple months of 5%+ were capped, but the 2 months of dropping were included. Imagine, owning an "investment" that should return some fraction of the S&P, up 23%, and you get zero.

  2. Index return? 30%. IU return 14%. Not as bad as 2009, but less than half the S&P return.

A more exhaustive analysis would show that treasuries would beat this ridiculous product.

This is the snapshot of 35 years of the strategy the FIA offers: enter image description here

First col, the sum of monthly returns per the crediting rules of the FIA, monthly gain capped at 2%, losses not capped. But, transferring to col 3, the return ignores down years. The S&P return ignores dividends. Trading the dividends for downside protection might make sense, but as you can see, the FIA return lags even that by over 5%. The S&P including dividends returned 11.54% over this time.

For those who are risk averse, and suggest that my math ignores this, that the client would be in cash, I looked up 3 month T-Bills. You can't get much cashier than that. The T-bill return over this period was 23% higher (the cash you'd get), 3.877% vs 3.162% for the FIA.

When I sat with a person to review this, years ago, the salesman refused the appointment. He told her that she saw his presentation, and needed to make a decision. In the notes she had from their meeting she wrote "annual return as high as 24%. Never less than 0." 50+ page prospectus, but no real historical sample returns. All calculations showed with awful years with the FIA protecting the client, or positive years where the returns were statistically improbable, and the return capturing 70-80% of the S&P return.

As I note in a comment. I'd be happy to see if these products have changed. From what OP described, it's exactly as I recall, and just as awful.

  • There is also yearly point to point product that wouldn't have as big a problem.
    – xiaomy
    May 19 '17 at 0:13
  • Your numbers are a classic argument of why young(er) people should invest in stocks in their pension plan, and keep it untouched in downturn. Unfortunately people get freaked out in crashes and tend to sell low buy high. Our utility function is not symmetric, losing a buck hurts a lot more than winning one. This FIA product caps growth, in exchange for guarantee of principal, and there are people out there that it caters to. Sales guys might be engaging in deceiving marketing behaviors for the high commissions but I don't see an inherent issue of the product.
    – xiaomy
    May 19 '17 at 16:56
  • Maybe that's my problem. If these products weren't sold via deceptive practice, they wouldn't exist. At least in the Whole Life thread, I can contrive examples where the product has a potential use. In this case, it lags the risk free rate. May 19 '17 at 17:22
  • Sales would definitely go down but it might be a stretch to say that they wouldn't exist without deceptive marketing. It really depends on how risk-averse one is. Naturally we would price a peace of our mind much more favorably during and after a crisis. That's why FIA was so popular after '08.
    – xiaomy
    May 19 '17 at 18:37
  • Also just to point out a technicality, last couple of decades saw a general trend of interest rate drop which led to favorable fixed income return and it's perceivable that we are in the early stage of rate increases. So going forward bonds probably wouldn't perform the same way as it did.
    – xiaomy
    May 19 '17 at 18:40

According to How does the cap on your fixed-indexed annuity impact potential interest? The upper cap "balances out the benefit and helps limit the contract’s risk exposure".

For example, say you have an indexed annuity and have selected the S&P 500 index allocation option. In a given year, that index sees a gain of 10% on the date of your contract anniversary. However, your annuity’s cap is 7%. That means the cap limit of 7% would be credited to your contract not the 10% the index returned. However, if the index change was 4%, your contract would be credited 4% because that is lower than the hypothetical cap.

You might view this limitation on the amount of indexed interest that can be earned each year as a drawback, but it’s an important feature that balances out the benefit and helps limit the contract’s risk exposure. Take that same indexed annuity, but now imagine the S&P 500 index saw a 4% loss over the year. Although you won’t receive any indexed interest for the year, you won’t lose any money as a result of that loss either. Early withdrawals, however, may result in loss of principal and credited interest due to surrender charges.

In exchange for allowing limited participation in any index gains, you avoid index risks. Capping the interest earnings on these annuities is the insurance company’s way of balancing the ebbs and flows of the market.

  • 1
    The referenced Doc skips over the math of how the monthly formula can take otherwise decent years and pretty much destroy the credit for the full year. As I note in my answer, I'll run numbers tonight. Curious to see what was left in a year like 2013. I'd bet, less than half the return. May 18 '17 at 12:22
  • @JoeTaxpayer The main point is (in the OP's words) that "negative changes" are limited. They are capped to zero. Not necessarily a bad thing at all, unlike the OP's version. May 18 '17 at 13:48
  • But, as I've read a couple prospectuses, a month with -4% and two months of +4% each will cancel to zero as the 2 that were positive were capped to 2%. The sales guy honestly said you could gain up to 24% per year, as if such a thing were mathematically probable. May 18 '17 at 14:20
  • @JoeTaxpayer Can you point to an FIA product that does monthly interest calculation? I've also looked at a few and they all guarantee principal by flooring the interest at zero (i.e. no negative interest).
    – xiaomy
    May 19 '17 at 0:00
  • Never mind. Apparently the guarantee horizon and the performance sampling periods aren't necessarily the same.
    – xiaomy
    May 19 '17 at 0:06

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