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Volatility Controlled Indexes: Everything You Should Know

RateVolatility_PostThe most recent innovation in the world of Index Annuities is the Uncapped Point to Point Managed Volatility Index. What makes the Index Annuity a very unique product, is the use of the call option by insurance companies. This allows gains to be realized when an index increases, and no losses to be incurred should the index decline. The price of the call option is what determines how much upside potential the index can have. What determines the price of the option? Two things: Volatility and Time.

What exactly is volatility? It is the degree of variation of a trading price over time, as measured by the standard deviation of returns. The standard indexes, such as the S&P 500 and the Dow, are very volatile indexes and therefore the call options are more expensive. This is why you don’t receive all of the gains of whatever index is being tracked within an index annuity. By the way, the company doesn’t keep the difference, as some financial pundits will mistakingly claim.

Overall among the different crediting methods within Index Annuities, (see post on crediting methods in Index Annuities), the Point to Point crediting method, has been the most consistent strategy as far as capturing gains each year. The only problem with this strategy for the majority of annuity contracts, are the gains are usually capped around the 2 to 6% depending upon the company and product. THAT IS WHY IT PAYS TO SHOP AND MAKE SURE YOUR GETTING GOOD RATES!!

 

volatility-control-2With the introduction of the Volatility Controlled Index, an index can be created and managed on a daily basis by moving between stock market instruments, bonds, cash, or commodities. By keeping the volatility at or near a certain level, the price of the call option that the insurance company purchases is much cheaper. This has allowed the majority of Volatility Controlled Indexes to be able to offer an Uncapped Point to Point strategy.  This can really help to improve overall returns in relation to capped strategies.

What we are seeing in the industry with these new strategies are also longer reset periods, from one year to as long as 5 years, since a call option with a longer time period is also less expensive. The two year reset period actually seems to be the sweet spot we are seeing as far as the highest overall returns without going too far out in the reset period. Going past two years brings in the added chance that during that period a market correction could occur which could add up to a zero return after waiting 3 to 5 years for possible gains.

There are now dozens of new indexes that have been introduced within the industry which has added another layer of complexity and due diligence on the part of the client and the agent, to identify the best indexes to use.  Let’s get under the hood and figure out how these work so we can get make sure we’re getting the best opportunity out there.

Study of Volatility

One thing that you will notice is the index will usually have a number next to it ranging from 5% to 10%. This number doesn’t refer to the return percentage, but the level of volatility. This number seems very ambiguous, so what does this actually mean? Let’s take a look at the volatility of the S&P 500 to get an idea.

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According to a study by Ed Easterling with Crestmont Research, since 1950 the S&P 500 has averaged around a 15% level of volatility. During this period volatility levels of the S&P 500 have been very low, near the 10% level, and also at times much higher, ranging near the 25% level. As a general rule when we see market corrections, such as 2008, volatility levels will usually increase dramatically.

How then does this relate to the percentage number next to the Volatility Index being presented? A 5% level would tell us that the goal of the index is to maintain a much lower level of volatility than the S&P 500, by using additional blends of cash, bonds or commodities, or by using the lowest volatile stocks in the S&P 500, or a blend of any of these.

So how would a higher number be different? If the number was instead 10%, then the Volatility Controlled strategy would allow for more deviation and therefore would have greater exposure to growth assets such as stocks or commodities.


Bottom Line

volatility-4So the general rule we can learn from this, is the higher the level of volatility, the more exposure to growth assets and therefore the greater the potential return. With this higher exposure to growth assets, in short periods of higher volatile markets, this will also cause the strategy to be subject to declines where a lower volatility level could be in safe assets.

During up and down years, the lower volatility index could actually do better, than the higher, but during strong growth years because of more exposure to growth assets, the higher volatile indexes will tend to do better. Don’t forget with the index annuity if the index goes negative you just get a zero!!

A consideration that one has to realize is with a lower volatility number, such as 5%, there can be periods of rising, more volatile markets, such as 2009 when the S&P 500 was up over 23%, where a lower volatility index may have only picked up 5 to 10% of the gain.

Summary

Overall, with the development of the Volatility Controlled Index, based on historical returns, they have performed better than the older crediting strategies by a few percentage points, and also increases the likelihood of more positive years. We have developed a page listing the latest Volatility Controlled indexes within index annuities on the marketplace today where you can track the daily prices and historical returns.

If you are considering an Index Annuity with a Volatility Controlled Index run it by us first and we will be glad to give you an objective analysis and see how it compares to other products to make sure you are getting the best possible opportunity.

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