It’s been roughly four years since volatility controlled index (VCI) crediting methods took off in the fixed index annuity space. Vol-controlled indices were a reaction to the protracted very low interest rate environment that had existed since 2011—when 10-year U.S. Treasury rates were under two percent and top-rated corporate bond yields were in the threes, there simply wasn’t enough yield to provide meaningful participation for an FIA in a traditional index. Volatility controlled indices were a way to buy more potential FIA interest because the overall gain is managed for volatility and thus the fear of a “long tail” payout is removed (a case where the index shoots up and the interest credited to the FIA far exceeds the amount received for the hedge). In the FIA world, vol-controlled indexes are a way to limit costs while still providing potential interest. The handful of indices four years ago became over fifty in only three years.
How have they performed? As with many traditional crediting methods there is a wide pattern. VCI returns are strongly affected by volatility, so when volatility is up the index spends much of its time sitting in cash. 2016 was a period of slightly higher volatility and the last 12 month returns ending during that year averaged two percent to five percent before deducting any spreads. 2017 had unusually low volatility that resulted in early year average 12 month returns of six percent to seven percent becoming 10 percent to 12 percent for index years ending in the fourth quarter. Indeed, some indices reported gains of over twenty percent. Thus far in 2018 volatility is a bit higher, so the average last 12 months returns have been running around seven percent, meaning fixed index annuities are generally being credited with five to six percent interest.
Whether you consider these returns good or bad depends on your expectations. On the whole, over the last three years the average net interest generated by a VCI in a fixed index annuity is higher than the average for traditional methods. If the VCI goal was to earn a bit more interest, one would be pleased. In fact, earning a bit more interest is the only realistic goal over time. This doesn’t mean you won’t ever hit a home run with a VCI, but you shouldn’t count on it.
When these came out I was asked to address the question: Can agents or consumers understand how VCI interest is calculated? My answer then and now is no. Although the concept can be conveyed, volatility controlled indices are complex mechanisms and getting more so. In addition, the vast majority of these indices have limited actual histories. Essentially, you are placing your faith with the index provider and counting on them. However, that is usually the case with most financial products.
I wrote the following conclusion to that first report from over four years ago and it is just as valid today. Volatility controlled index crediting methods are a creative way to provide more value to the annuity owner in a low interest rate environment by effectively raising general index participation. The concept is valid and my modeling shows that vol-controlled indices could provide higher overall annual credited interest than what may be obtained from most caps and rates using other methods. The main potential problem is one of consumers creating unrealistic expectations of the interest they may earn and benchmarking the potential returns against the stock market and not other fixed annuities.
