Saturday, November 23, 2024
Fixed Indexing, sometimes referred to as Equity Indexing, in annuities, may be the single most significant innovation in personal finance and investing in the last 25 years. Fixed Indexing offers annuity investors the opportunity for non-trivial returns with no risk of loss. No other financial product can make such a promise. This has resulted in record sales and over $500 billion in assets invested. Volatility Controlled Index crediting options advance this ethic of innovation. But why? And how?
In order to understand Volatility Controlled Indexed Annuities, how they work and why they’ve been developed, we must first understand the conventional indexes, such as the S+P 500 and the Dow Jones Industrials. We must also understand how a Fixed Indexed Annuity works – how it credits interests and protects investors from market declines.
The first point to understand is that when you invest in a Fixed Indexed Annuity, you are not investing in the index itself. Your investment is in a Fixed Annuity. That is an insurance product that offers, among other things, a Guaranteed Life Income option and a principal guarantee. A Fixed Indexed Annuity is first and foremost a Fixed Annuity. A Fixed Indexed Annuity differs only in how the interest you earn is calculated and credited.
In a traditional Fixed Annuity, you earn a guaranteed interest rate, declared each year, by the insurance carrier. While other market factors apply, this rate is primarily a function of the yield on the carrier’s investment portfolio. If you invest in a traditional Fixed Annuity, you will know, in advance, the interest you will earn each year. That interest is then added to your account balance and becomes the base upon which interest will be earned and credited in subsequent years.
While the declared interest rate can and will change from year to year, your principal is always guaranteed. In other words, you can never experience a negative annual return.
Fixed Indexed Annuities are identical on all accounts except for the carrier’s method of calculating the interest you will earn. Because your earnings on a Fixed Indexed Annuity are based upon the performance of an index, it cannot be declared in advance. Like all fixed annuities, whatever interest you do earn is guaranteed, cannot be lost regardless of how the index may perform in the future, and is added to the base upon which future interest will be earned and credited.
As we said earlier, you don’t own the index or any of the stocks inside of it. Indexes can and do fall and your Fixed Indexed Annuity investment is guaranteed never to do so. The insurance carrier doesn’t own the index either (at least not in this context – it might hold an index elsewhere in its portfolio). So how can the insurance company offer you returns based upon the performance of an index, with no risk of loss and without actually owning the index or any of its components?
To understand the answer to this question -- and we must understand it -- we must discuss one of the most complex and confusing topics in all of finance: OPTIONS.
A full discussion of options is well beyond the scope of this article, and readers are encouraged to do their own research to further their understanding. But be forewarned! Volumes have been written. Nobel Prizes granted! It’s complicated!
Briefly, an option is a derivative. Its value is derived from the price of an underlying asset. In this context, the underlying asset is an index, such as the S+P 500, for a particular time period, such as a year. Options are leveraged instruments. That means that a 10% change in the price of the underlying asset or index could result in a 100% increase in the option’s value. Or more. An investor can use options to hedge against or to speculate upon the direction of an index.
Let’s look at three of the more common interest crediting strategies offered in Fixed Indexed Annuities, how they work and the options strategy underpinning them. For our example, let’s assume all are based on the performance of the S+P 500 index.
Annual Point-to-Point with a Cap: If the Cap is eight percent and the index increases by five percent during your policy year, you will earn five percent interest on your account value. If the index is up eight percent, you will earn eight percent. But, if the index is up ten percent, you will earn just eight, the amount of the cap. As with all fixed annuities, you cannot lose money so, if the index falls for the policy year, you will earn no interest but suffer no loss. Your return for that year is zero.
The Annual Point-to-Point with a Cap interest crediting strategy corresponds to the Covered Call options strategy. A Covered Call strategy involves the buying and selling of options at different prices.
With the index at 1000, options (let’s say ten for our example) are purchased at a strike price of 1000. At the same time, ten options are sold. The options that are sold are said to cover the options that are purchased. If the cap is at eight percent, ten options will be sold at a strike price of 1080, eight percent above the strike price of the purchased option.
Annual Point-to-Point with a Spread (or Hurdle Rate): Now, let’s take a look at the Spread interest crediting strategy. If the Spread or Hurdle Rate is five percent and the index increases by fifteen percent, you earn ten percent interest. If the index is up five percent or less, you earn a zero for that year. Of course, if the index is up thirty percent, you earn 25%. The spread is subtracted from the gross return and the result is the interest you’ve earned for that policy year. Whatever interest you do earn is guaranteed in subsequent years.
This strategy corresponds to an Out of the Money Call Options strategy. If the Index is at 1000 and the Spread is five percent, ten options, to continue our example, will be purchased at a strike price of 1050, five percent above the price of the index. The options are said to be five percent out of the money.
Annual Point-to-Point with a Participation Rate: If the Participation Rate is sixty percent and the index increases by ten percent, you will earn six percent. If the index is up twenty percent, you’ll earn twelve percent. Again, you cannot lose money. If the index declines, your return will be zero for the year.
In this case, if ten options would be required to track the index fully, just six are bought. The six purchased options enable you to “participate” in sixty percent of the index’s return.
A cap, spread, or participation rate, lowers the cost of the strategy. The level of the cap, spread, or participation rate, is a function of the carrier’s “options budget.” That is, the amount that the carrier can spend, out of the expected return on its portfolio, and still operate its business and earn a profit. The options budget, in turn, is primarily a function of two factors: The yield on the carrier’s investment portfolio and the cost of options on the target index. The cost of options on the target index is, in turn, primarily a function of that index’s volatility.
All things being equal, a lower yield will result in a lower option budget and a lower cap or participation rate, or a higher spread. Likewise, all things being equal, a more volatile index will result in more expensive options and, therefore, a lower cap, participation rate, or a higher spread.
In an environment of historically low-interest rates, carriers’ options budgets are already exceedingly thin. Combine that fact with a spike in volatility, such as we have seen in recent years, and the attractiveness of a Fixed Indexed Annuity tied to the S+P 500 or other equity indexes rapidly decreases. In many cases, caps have declined to four percent or less.
Sometimes it seems as if there is an index for everything: stocks, bonds, interest rates, large caps, small caps, commodities, and housing prices. There is even an index that claims to track Paper and Cardboard. Most indexes attempt to be a proxy for a sector of the economy or the economy as a whole.
Volatility Controlled Indexes are different. Their objective is not to provide a snapshot of the economy or of an industry but to target a maximum volatility, typically five or ten percent, and achieve maximum growth consistent with that target.
There are a number of Volatility Controlled Indexes developed primarily by investment firms and they use various, often proprietary, strategies for controlling volatility. For example, an index might allocate between three asset classes: stocks, commodities, and bonds, and periodically reallocate from an asset class with a higher or increasing volatility to one with a lower or decreasing volatility.
In all cases, the cost of options on one of these indexes will be just a fraction of those on a major index. That means no caps, no spreads, and participation rates that often exceed one hundred percent.
If the Participation Rate is one-hundred-fifty percent and the Volatility Controlled Index increases by ten percent, you earn fifteen percent on your annuity investment that year. This result is achieved by purchasing fifteen options on the index instead of the ten we’ve used in our previous examples.
However, it is crucial to keep in mind that Volatility Controlled Indexes, because they are diversified between several asset classes, including bonds, are likely to have more modest returns than the conventional indexes. Controlling for volatility is a double-edged sword. Options, which are central to the Fixed Index Annuity are substantially less expensive. On the other hand, volatility is a benefit to the Fixed Index Annuity investor because, by design, Fixed Index Annuities have no downside risk. Whatever volatility there may be for the Fixed Index Annuity investor will always be to the upside.
So, what is a Fixed Indexed Annuity investor to do? This author has read a study that claimed that the best indexing strategy was a spread on the most volatile index, for example, the Nasdaq 100. Other studies indicate that the Participation Rate is best because it is both uncapped and will participate in any year with an extraordinary return but still return something in years with more modest moves.
Yet, the S+P 500 with a cap has been and remains the most popular choice among Fixed Index Annuity investors.
Volatility Controlled Indexes are likely to have few negative years, so fewer zeros, but few years where the index returns more than ten percent. Still, those returns are uncapped, produce interest during any year that the index has a positive return, and could be further increased by a participation rate over 100%.
Many annuity carriers allow investors to diversify. That is, you can split your investment among two or more strategies. In this case, the best choice might be to allocate a portion of your investment into the Volatility Controlled strategy and a portion into an uncapped, spread strategy on the most volatile index available.
Speaking personally, as someone who was, at the time, a grizzled veteran of the financial services industry and who thought he had seen everything, the introduction of Equity Indexed Annuities blew my mind! Volatility Controlled Equity Indexes have done it again!
