What Are Volatility Control Indexes? What Does It Mean For You As An Annuity Holder and Advisor?

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What Are Volatility Control Indexes?

Introduction

Often, when we talk about fixed-indexed annuities, we come across several index strategies – different indexes designed by different index providers, different return objectives, risk goals, and portfolio styles. On top of it, we also come across terms like “Volatility Control Index,” “Risk-controlled Index,” “Daily-risk control Index,” “Excess Return Index,” etc. Amidst so many options and jargon, we often become overwhelmed about what indexing strategy to choose from.

An annuity is a financial product that offers a guaranteed stream of income for a certain period of time or for the rest of one’s life. Annuity companies use various strategies to invest the premiums they receive from policyholders. One such strategy is to invest in risk-controlled indexes, which are designed to provide exposure to a specific market while reducing the volatility of returns. In this blog, we will discuss what risk-controlled indexes are and how annuity companies use them to manage risk and generate returns. We will also discuss how these affect you as a policyholder and what indexing strategy you should choose.

What are Risk-controlled Indexes?

A risk-controlled index is an investment index that is designed to reduce volatility and provide a more stable return. This is achieved by using a rules-based methodology that adjusts the index’s exposure to risk based on market conditions. The goal is to participate in market gains while limiting the impact of market downturns. But this is not the entire story! We will discuss the “dark” part of this in a later section of the blog.

There are several types of risk-controlled indexes, including:

Volatility-Targeting Indexes: These indexes are designed to maintain a consistent level of volatility over time. They adjust the exposure to risky assets, such as stocks, based on the level of volatility in the market. When volatility is high, the exposure to risky assets is reduced, and when volatility is low, the exposure to risky assets is increased.

Suppose an annuity company offers a fixed-indexed annuity product that is linked to a volatility-targeting index. The index provider uses a rules-based methodology to adjust the exposure to risky assets based on changes in the level of volatility in the market. Let’s say the index has a target volatility of 10%.

At the start of the year, the annuity company invests $100 million in a portfolio of assets that replicate the index. The index provider determines that the current volatility of the market is 12%. As a result, the exposure to risky assets is reduced by 20% to bring the volatility of the index down to the target level of 10%.

Minimum Variance Indexes: These indexes are designed to minimize the volatility of returns while maintaining exposure to a specific market. This is achieved by selecting stocks with the lowest historical volatility and adjusting the weights of each stock to achieve a target level of risk.

Suppose an annuity company offers a fixed-indexed annuity product that is linked to a minimum variance index. The index provider uses a rules-based methodology to select stocks with the lowest historical volatility and adjust the weights of each stock to achieve a target level of risk. 

Let’s say the index has a target level of risk of 10%. At the start of the year, the annuity company invests $100 million in a portfolio of stocks that replicate the index. The weights of each stock in the portfolio are adjusted to achieve a target level of risk of 10%.

How Annuity Companies Use Risk-Controlled Indexes

Annuity companies use risk-controlled indexes to manage the risk of the investments they hold to support their policy obligations. 

A fixed-indexed annuity is a product that provides a guaranteed minimum interest rate and the potential to earn additional interest based on the performance of an index. Fixed-indexed Annuity companies may use risk-controlled indexes, such as volatility control indexes or minimum variance indexes, to manage the risk of the investments they hold to support the guaranteed minimum interest rate. The use of these indexes allows annuity companies to participate in market gains while limiting the impact of market downturns, which is critical for their business model. 

However…!

The Complete Story…

The increasing use of volatility control indexes suggests a pattern; that the companies issuing fixed indexed annuities are using these volatility control indexes not actually to manage risk but to limit the potential return a policyholder can earn. Remember that your gain is their loss. In a fixed-indexed annuity, you are protected from market downside risk, and the annuity issuing company will have to pay you the minimum guaranteed rate, even if the market goes negative.  Thus, they would not simply allow you to earn the complete market upside. Besides the return-limiting tools like participation rates, spreads, cap rates, etc., they also use risk-control/volatility control indexes as a crediting strategy, which are deemed to have low downside AND low upside.

Same Indexes – One Regular and One Volatility Control? 

Without delving deeply into the print lines, it is difficult to discern the true differences between two seemingly identical indexes. One can find carriers that do use identical volatility-controlled indices, where simply looking at the spreads would tell you which could post a higher return; However, these instances are rare, as volatility-controlled indexes are generally intricate and complex.

A volatility-controlled index has a predetermined numeric target for volatility, which is aimed to keep the overall index volatility at or below the specified level. This is achieved by shifting funds from the equity side to the low-volatility side as the volatility in the equity index(es) increases, and the reverse happens when volatility decreases. As a result, the overall volatility stays within or below the targeted level. For an index to be considered volatility-controlled, there must be a specific trigger for the entire index. While some indices may discuss volatility management, they do not qualify as volatility-controlled unless they have a defined trigger that necessitates reallocation.

VCI Returns – Reality Check

The fundamental principle of volatility-controlled indexing (VCI) follows the same logic as averaging or monthly cap methods, whereby higher volatility should reduce maximum gains, as markets tend to experience regular volatile periods. In essence, higher volatility moves VCI funds out of the stock market and into cash. Although volatility is more pronounced during market declines, it also increases during periods of exuberance. Therefore, a crediting strategy that withdraws from the market during high volatility periods should provide protection for the hedge seller (the annuity company) from incurring excessively high payouts.

The events of 2016 serve as a prime illustration of this phenomenon. Despite the S&P 500 registering a 9.5% gain, the average return for volatility-controlled indexes (VCIs) – before factoring in spreads – was a mere 3.5%, with the majority of fixed-indexed annuity VCIs providing interest credits of 0% to 1%;  the high for one-year periods was around 4.75%.

The scenario in 2017 presented a contrasting situation. Firstly, stock market returns were substantial, with the S&P 500 delivering a 19.4% gain. The other significant factor was the near absence of volatility. As a result, the average return for volatility-controlled indexes (VCIs) – before spreads – was 12.6%. The net credited VCI interest typically ranged between 7% to 9%, although many fixed-indexed annuities (FIA) VCIs posted returns in the mid-teens, surpassing double digits. 2017 proved to be a highly rewarding year for investors involved in volatility control indexing, but the returns were still way less than they could have earned on a similar index without a volatility control mechanism.

The performance in 2018 presented a distinct narrative. Before deducting fees or spreads, the average volatility-controlled index for fixed-indexed annuities incurred a loss of 3.3%.

The year 2019 proved to be a robust period for volatility-controlled indexes. Half of the indices yielded double-digit returns, with fifteen recording gains of over 15%. The average fixed-indexed annuity volatility-controlled index gained 10.3% before deducting fees.

Despite the initial uncertainty in 2020, the year ended on a relatively positive note. While around a quarter of the volatility-controlled indexes incurred negative returns, the remaining indices registered an average gain of 2.8%. However, fixed-indexed annuities utilizing conventional indexes typically provided more interest with less volatility. The below chart depicts the average pre-spread or pre-cap gross return of fixed-indexed annuities’ volatility-controlled indices (represented by the black line) and the varying range of returns of different indices (purple) over the year 2020, concluding at the end of each month. However, as fixed-indexed annuities do not acknowledge losses, the chart registers a minimum of zero, notwithstanding the fact that some indices incurred losses.

Less volatility equals less downside, too, you may argue!

Remember that as a fixed-indexed annuity investor, your returns have a floor of 0%. If the index is performing badly, the worst you can earn is no return. Even for an index with a volatility control mechanism in place, the return will still be close to 0% if the index is performing badly. So as a fixed-indexed annuity holder, you actually have no tangible incentive to opt for an index with a volatility-control mechanism.

Essentially, what I want to convey is that volatility-control indexes – although they are sold to annuitants as less-risk indexes, it is important to keep in mind that their returns can be substantially less than a similar index with no volatility control mechanism.

Now, it doesn’t mean that all VCI indexes are bad. There are some indexing strategies that offer very good participation rates on VCI indexes, which more than compensate for the volatility control limitation that they come up with. We keep posting unbiased annuity product reviews on our blog, where we also comment on the indexes and strategies that come up with the annuity product. You can check them out here. If you want to get a particular annuity product reviewed, let me know in the comments.

Excess Returns Index – Bigger Red Flag!

A calculation for excess return subtracts the risk-free rate from the gross return. The rationale for this is to enable the index provider to regain what they would have earned if the money had been left in the bank. However, it is questionable whether many consumers comprehend that a risk-free rate of 2% means a deduction of 2% from their gross index return before applying participation rates, spreads, or caps. Furthermore, I am apprehensive that some of the newly introduced non-volatility-controlled indices not only use a risk-free benchmark but frequently omit details on how the benchmark is computed.

The proportion of indices that incorporate an excess return component has significantly increased. The essential point is that with an excess return component, the benchmark return is subtracted from the gross return to determine the amount of “excess” return that the annuitant will earn. To illustrate this concept, suppose the benchmark return is the 3-month LIBOR rate, and the gross index return is 6%. In 2016, the 3-month LIBOR rate was 0.6%, resulting in an “excess” return of 5.4%. Then in March 2019, the 3-month LIBOR rate was 2.6%, so the “excess” return for the annuity owner would have been 3.4% before any deductions for spreads.

In many annuities, we see very high participation rates for some of the indexes – as high as 300%! Next time when you purchase an annuity for yourself, do check the finer details of the indexes providing 300% participation rates. It is a good chance that the index would be an excess return index with a benchmark that will subtract most of the index return. It is important to keep in mind that when something appears too good to be true, it often comes with its own set of complex terms and conditions that may be challenging for the average annuity holder to navigate.

Backtesting / Hypothetical Returns – Another Red Flag

When buying a fixed indexed annuity, many a time, we come across a new index of which we have never heard before. For these indexes, the annuity companies often provide us with backtested returns that look lucrative. You should be informed that backtested returns are calculated on certain assumptions that might not work in the real world. I am not saying that they are always wrong, but you should always be reminded that past returns – whether hypothetical or real – past returns never predict future returns in any way, shape, or form. 

Look out for Consistency in Indexes – Carriers may sometimes remove an index from further investment due to capacity constraints, causing frustration and distress for advisors and prompting concerns from investors who have invested considerable effort in comprehending an index that has been delivering strong returns.

Ideally, the set of indices that underlie a fixed index annuity (FIA) should remain consistent over the product’s lifespan, allowing advisors to conduct thorough research and make recommendations based on a fixed set of indices. 

Conclusion

Risk-controlled indexes are an important tool for annuity companies to manage the risk of their investments and provide policyholders a guaranteed income stream. These indexes allow annuity companies to participate in market gains while limiting the impact of market downturns, which is critical for their business model. To address the prolonged period of low-interest rates, a new solution in the form of volatility-controlled indices has been introduced for Fixed Index Annuities (FIAs). Typically, these indices have a limited or no historical performance record. However, you must have very realistic return expectations from these indexes. 

Employing managed volatility allows for a higher nominal participation rate. An index utilizing this strategy may provide a >100% participation rate without an explicitly stated cap. Nevertheless, it’s important to note that nominal participation may not equate to effective participation. Even though an index with controlled volatility may offer a >100% participation rate according to its methodology, it may only result in a fraction of the overall gain of the underlying index in reality. If you don’t understand these indexes, you should simply stick with regular indexes such as the S&P 500, Dow Jones, Russell 2000, without any volatility control mechanism.

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