The appeal of an indexed annuity is that it is a savings vehicle which credits interest based on an index, such as that of a stock market.

At the end of a contract year, if the index has increased, some or all of the increase is credited to the annuity. If, on the other hand, the index has decreased, the annuity’s value is protected from the decline.

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That has been a winning value proposition for years for consumers and the companies that offer these annuities.

As for the index itself, the most popular option has always been the S&P 500.

But over the last four years, another very popular choice has arisen: the volatility-controlled index.

Unique Assets Provide Protection

The enduring appeal of the S&P 500 index is that it is well understood. Agents and consumers know what it is and how it works. Not only that, the performance of the S&P 500 index is widely reported in the financial press, so clients may generally know what’s going on with their annuity value just from following the business news.

Volatility-controlled indices are different. They tend to carry the brand name of a prestigious investment bank. If your favorite carrier has an annuity using an index branded by an investment bank — such as JP Morgan, Barclays, Deutsche Bank, Goldman Sachs or BNP Paribas, for example — chances are it is a volatility-controlled index.

A volatility-controlled index tracks a basket of assets that changes regularly with the goal of making the index fluctuate up or down less than the S&P 500 index. While these indices have that characteristic in common, each insurance company tends to offer its own unique volatility-controlled index. Since each index is different, agents and consumers need to make more of an effort to understand how each particular index works.

The benefits of volatility-controlled indices for insurance companies, agents and consumers are:

• The index can be uncapped, so there is theoretically no limit on potential upside interest crediting for the consumer
• The index can include multiple asset classes, not just stocks
• The performance of the index can include dividends on any stocks in the index
• The index can be unique, making the product different from any other product in the marketplace
• And yet, the cost of the option contracts that the insurance company must buy to back the annuity are cheaper and more stable over time on volatility-controlled indices than on the S&P 500 index

How is it possible for an index to do all of this? The key is understanding how the volatility control works.

A Balance to Limit Volatility

As an insurance agent or financial advisor, you understand that the stock market is volatile. Sometimes the market is relatively calm, while at other times, it is more unstable. Thus the S&P 500 index, since it consists solely of stocks, has an amount of volatility associated with it that varies over time. Sometimes, when the markets are calm, the S&P 500’s volatility is low. Other times, such as when the market suffers a correction or crash, the S&P 500’s volatility is high.

A volatility-controlled index, instead of consisting entirely of stocks, is only partially made up of stocks. A portion of the index typically consists of cash, which has zero volatility. During times that stock volatility is high, a volatility-controlled index adjusts its mix of assets to use more cash and less stock. This lowers volatility back to the desired range.

This can result in the benefits listed above because the index is partially zero-volatility cash. And, since cash offers little or no rate of return, the options that insurance companies must buy to back their index annuities are cheaper. This allows companies to come much closer to purchasing options on the full performance of the index. Rather than having interest crediting limited by a participation rate or a cap rate, insurance companies can provide the full uncapped performance of the index, perhaps less an annual spread rate.

Also, insurance companies can work with investment banks to bundle a more exotic collection of assets than just stocks, and do it in a way that makes their index unique from any other index in the marketplace. Regardless, mixing cash into the index brings the overall volatility, and therefore the option costs, down to the desired range.

The Pros and Cons

There are pros and cons of uncapped volatility-controlled indices from the agent’s and client’s perspective. The pros are:

• There is often an interesting story to tell as to why the index may outperform the more common S&P 500 index
• The investment bank’s brand name can lend additional prestige to the product
• There often isn’t a hard cap, so theoretically, there is unlimited upside interest crediting potential

The cons are:

• The index typically doesn’t have a real history
• The mix of assets and cash may constantly change
• The resulting performance may not be as easy for the client to understand

While the S&P 500 remains the most popular index for an index annuity due to its simplicity and familiarity, volatility-controlled indices have become very popular as well. This popularity has extended the appeal of the index annuity and may make the volatility-controlled index annuity the right fit for your clients.