The 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!!
With 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.