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Limitations of uncapped strategies

The limitations of uncapped strategies on indexed annuities

One of the appeals of the indexed annuities is the ability for investors to benefit from the upward movement of a market index without taking on any of the market risks.

One of the main downsides of indexed annuities is there is usually a limit to how much of the market’s increase the annuity is credited. Many indexed annuities come with a cap, which is a ceiling on interest rate growth.

A typical cap might be 8 percent. That means your annuity’s account value can not increase more than 8 percent in any one period, regardless of how much the benchmark index increases. If the index increases 5 percent, your account value will increase 5 percent. If the index climbs 12 percent, the account value will be limited to 8 percent.

To alleviate this limitation, may insurance companies have in the past few years added uncapped strategies to the interest crediting method options.

On the surface, it would seem that an uncapped strategy provides unlimited growth. But because indexed annuities do not lose principal, there has to be a limit on their upside. Otherwise the insurance company is taking on too much risk.

What it means to have an uncapped strategy is that the annuity crediting method uses something other than a cap to limit the upside growth. Some of those techniques include:

A spread
A spread acts like a floor. If your annuity has a 5 percent spread, your account value will increase by whatever percentage above 5 percent the corresponding index goes up. If the index increases 7 percent, your account value will grow 2 percent (7 – 5). If the index climbs 15 percent, your account value will earn 10 percent. But if the index only increases 3 percent, your account value will earn nothing for that period.

A lower participation rate
A participation rate is a percentage of the index growth that the insurance company will credit to the annuity account value during a given period. Participation rates are usually found in point-to-point indexing strategies. The higher the participation rate, the more interest you will be credited with when the market index increases.

For example, an indexed annuity may have a participation rate of 80 percent. This means on a one-year point-to-point strategy; the annuity will credit 80 percent of the index growth during the contract year. So if the index increased 10 percent during the contract year, the account value would only be credited 8 percent (10 x 80% = 8 percent). If the index increased 4 percent for the year, the account value would be credited with 3.2 percent interest (4 x 80% = 3.2 percent).

For uncapped strategies, the insurer will likely set the participation rate a lower level, to something like 50 percent.

A volatility control index
Volatility Control Indexes, sometimes referred to as hybrid indexes, are actively managed to limit the extreme highs and lows of index movements to help stabilize index returns. These indexes limit the overall amount of risk in volatile and unpredictable markets. They typically combine equities, fixed income vehicles and commodities and set an allocation based on an algorithm that measures the momentum of the equity portion.

When market volatility is relatively low, the index will maintain its exposure to the equities that are part of the index. When volatility increases, the index is reallocated so that it is weighted toward risk-free assets, such as cash. Then when volatility falls again, the index shifts away from the cash investment and the index’s exposure to the underlying index increases.

Using a volatility controlled index allows the insurance company to provide an uncapped crediting strategy while maintaining the downside protection inherent in indexed annuities. The VC index protects you the consumer by limiting the downward volatility, but also limits the risk to the insurance company by restricting upward volatility.

An allocation requirement
Another way insurance companies can mitigate their risk on uncapped strategies is to require the annuity holder to allocate a minimum portion of their premium is to a fixed interest account. For example, you may be required to put at least 40 percent of your premium into a fixed account and then be able to put the other 60 percent in the uncapped strategy.