Envestnet Whitepapers

Annuities as an Asset Class for Fee-Based Advisors l 25 © Envestnet 2022 The one-year term and the point-to-point method means that the changes in the index values on one-year contract anniversaries will be used to calculate interest. Annual point-to-point looks at the change in the index at two different dates, one year apart. At the end of each yearly term on the anniversary date of the contract, the interest-crediting formula uses the index gain for that year (the price return, not including dividends) to credit interest. A floor of 0 percent is protected, and a participation rate determines the percentage of upside gains that are credited. As for the annual reset design, this reflects how interest crediting calculations start fresh for each term. If the index lost 10 percent in the previous year and the FIA credited 0 percent interest for that year, it is only the new point-to-point change for the current year that matters to calculate the new term's interest. There is no need for cumulative gains to make up for previous losses when the annual reset provision is included. A simple way to think about the downside protection with the guaranteed floor is that the insurance company buys enough bonds with the annuity contract value that the growth of that portion with interest will match the original contract value at the end of the term. With what is left after purchasing bonds to protect the principal, the insurance company keeps a portion to cover company expenses and profit motives, and the remainder is the "options budget" used to purchase upside exposure to the index. When the FIA offers a participation rate on upside, the insurance company can use the "options budget" to buy a one-year at-the-money call option on the S&P 500 index. This is a financial derivative that provides its owner with the right, but not the obligation, to buy shares of the S&P 500 at the option's strike price. The option is at-the-money if the strike price matches the current value of the index. If the index loses value during the term, the option expires worthless, and principal was protected with the bonds. If the index experiences capital gains (not including reinvested dividends) during the term, the owner receives exposure to the upside through the call option. The participation rate is the ratio of the "options budget" to the price of the call option, which provides the percentage of index gains received. Because there is a cost for creating protection for the contract value against a loss when the index declines in value, one should not expect to receive the full upside potential from the index. The call options will generally cost more than the size of the options budget. FIAs do not provide a way to get the returns from the stock market without accepting the risk of the stock market. A simple way to think about the downside protection with the guaranteed floor is that the insurance company buys enough bonds with the annuity contract value that the growth of that portion with interest will match the original contract value at the end of the term.

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