Should you use more than one index?
June 4, 2011 by Jack Marrion
- BY Jack Marrion
Roughly 4 out of 5 premium dollars placed into index annuity indices today have interest crediting linked to the S&P 500 index, which was the original index. The first additional indices were offered by Jackson National Life and included the S&P 400, Nasdaq 100, and an international index.
In 1999, American Equity became the first carrier to offer the Dow Jones 30 (DJIA). Today, a majority of carriers offer different index choices that range from the Russell 2000 to the Hang Seng. Although use of the S&P 500 has declined a bit as other index choices have grown, it is still, by far, the predominant index, which is why the index returns I usually report are based solely on S&P 500-linked methodologies. However, use of other indices continues to grow.
If you compare the 12-month returns of various indices over the previous 10 years — with negative returns reported as zero gains, reflecting the annual reset approach of index annuity interest crediting — the mean annual returns were: Dow‑7.6 percent; S&P 500‑8.1 percent; Nikkei 225‑9.2 percent; Nasdaq‑11.2 percent; Russell 2000‑12.3 percent; and Hang Seng‑15 percent.
Based on these numbers, and similar results going back roughly 30 years, it does make sense to use multiple indexes if the index participation is roughly equal or the indexes are not well correlated. The Russell, Nasdaq, and Hang Seng returns averaged about 50 percent higher than the S&P 500. Adding these indices might provide a boost to index annuity interest.
Zig vs. Zag
The four U.S. indices have return correlations over 90 percent, which means when one zigs in a particular direction they all zig in the same way. However, some of the foreign indices (and some new commodities indices that will be offered in the future) sometimes zag when the S&P 500 zigs, meaning that even if these foreign indices offer lower caps they may well outperform the S&P 500 at times.
For example, the Hang Seng only moved similar to the S&P 500 76 percent of the time while the Nikkei 225 mirrored the S&P 500 only 58 percent of the time. Periodically, these indices produced strong gains when the U.S. markets were flat. But don’t pick indices simply because they have low correlation. The reason may be because the index was down a lot when everyone else was reporting gains.
Using additional indices provides more opportunities to earn interest, and because it is an index annuity the annuity owner isn’t going to lose money by picking the wrong index. Try to find indexes with lower correlation (if you have the S&P 500, don’t add the DJIA) and don’t dismiss one index if the cap is slightly lower than another because it may provide positive zag.