An explanation of volatility controlled index strategies

An explanation of volatility controlled index strategies

Indexed annuities were created to combine the upside of variable annuities with the safety and guarantees of fixed annuities. They earn interest based on the movement of a market index, giving them the ability to grow higher in value than fixed annuities that charge a flat rate of interest. However, you are not actually invested in the market or in any index. The insurance company simply uses the index as a measuring stick for how much to credit to your contract.

Indexed annuities also have a provision whereby the contract cannot lose value based on how the corresponding index performs. If the index loses 5 percent, 15 percent or even 75 percent in a given period, the annuity’s account value remains steady. Zero interest is the worst your contract can return in a given period. This makes it a safer alternative to a variable annuity.

Because indexed annuities do not lose principal, there has to be a limit on their upside. As an indexed annuity holder, you’re essentially trading unlimited interest rate growth for the protection against negative returns. One way to do this is imposing a cap rate, which is a ceiling on interest rate growth.

Insurance companies have had difficulty in recent years setting their cap rates because of the low-interest rate environment. The higher interest rates are, the more the insurer is earning on its investments and the higher the cap rate it can afford to set on its indexed annuity products. Lower rates mean lower caps, which greatly limits the accumulation potential for annuity owners.

To address this dilemma, insurance companies have in the past few years introduced uncapped crediting strategies linked to volatility-controlled indices.

What is a volatility controlled index and how does it work?
If you’ve ever watched gymnastics, figure skating, diving or other sport where competitors are judged on performance, you may sometimes notice that a competitor’s overall score does not include the highest or lowest scores given by the individual judges. This is meant to provide a more accurate assessment of the athlete’s performance by eliminating the most bullish and most discriminating evaluations.

Volatility Controlled 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.

Uncapped, but not unlimited
Although some research shows that VC indexes will outperform those without volatility control, consumers should be careful about jumping right into annuities with these crediting strategies. Often, these strategies are heavily marketed for being uncapped, giving consumers the impression they offer unlimited upside and no downside.

It is not possible for an insurance company to provide this combination because it would be assuming unlimited risk. The only way to earn unlimited upside on an annuity is to purchase a variable annuity that would also expose you to unlimited market downside risk.

The VC indexes may be uncapped, but they are not unlimited in their growth potential. The uncapped indexed annuity will grow in sync with the market, but within a narrower range. The way the index is structured and managed will limit their upside without imposing a cap.

That doesn’t mean you should automatically dismiss an annuity with VC indexed crediting strategy. It means you should understand how the index works and what it’s historical returns have been before making a decision.