High water mark

The high water mark is one of several methods an equity-indexed annuity (EIA) can use to calculate the interest credited to the contract. Instead of comparing the index's starting value to its ending value, the insurer looks back over the entire term and uses the highest index value recorded on any policy anniversary as the ending point.

Here is how it works in practice. Suppose the index starts the term at 1,000 and its values on the next three anniversaries are 1,100, 1,250, and 1,150. Under a point-to-point method, the credited gain would be based on the final value of 1,150 — a 15% index gain. Under the high water mark method, the insurer instead uses the anniversary peak of 1,250, a 25% index gain, before applying the contract's participation rate and any cap.

The method's appeal is protection against a late-term decline: an investor locks in credit based on the best anniversary value even if the index falls afterward. The tradeoff is that insurers offering high water mark crediting often pair it with lower participation rates or caps, and the benefit may only apply if the contract is held to the end of the term.

The same idea appears in hedge fund fees, where it protects investors from paying twice for the same gain. Under a high water mark provision, the manager collects the performance fee — the "20" in a 2 and 20 arrangement — only on profits above the fund's previous peak value. If the fund falls 20% one year, the manager earns no performance fee until investors are made whole and the fund trades above that prior high.

The Series 65 exam covers equity-indexed annuities as insurance-based investment vehicles, and understanding crediting methods — high water mark, annual reset, and point-to-point — helps you answer questions about how EIA returns are calculated and why they differ from direct index investments.