Fixed Index Annuity Vol-Controlled Indices

ADVANTAGE COMPENDIUM

FIA Volatility Control Index Overview 1

December 2015

COMPENDIUM

Fixed Index Annuity Vol-Controlled Indices

A A little over two years ago Allianz introduced the next generation volatility controlled index in the fixed index annuity (FIA) annuity market, the Barclays US Dynamic Balance Index. Today, over a dozen and a half FIA carriers offer over two dozen volatility controlled indices with roughly a dozen more new indices either filed with the states or waiting to be filed. Why has there been an explosion of vol-controlled indexes in the FIA space? How do they differ from one another? What are or should be the concerns associated with this new interest earning tool? These are the foci of this paper.

Unlike many of the research topics studied by Advantage Compendium that result in a single report, the attention paid to volatility controlled indexes will be ongoing. This will be a series of reports that takes snapshots of the specifications of FIA vol-controlled indices used at that point of time as well as commenting on the then current concerns and events that might affect them. Since index launches follow an irregular pattern, future studies will be released whenever there are enough changes to warrant a revised study.

I'll conclude this introduction with the study's conclusion. Volatility controlled index crediting methods are a creative way to provide more value to the annuityowner in the current 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 returns than those obtained at current caps and rates on 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.

An Idea Borne Of Its Times Average composite bond yields dropped from around 7% in 2009 to under 4% by 20121. Although the prices on the options used by carriers to hedge the index-linked interest provided by FIAs remained competitive from an historical perspective, these falling bond yields meant there was less and less left over to buy the options. The result was fixed index annuity interest caps of 2% to 3% on broad based indices for many products. Volatility control indices for fixed index annuities (FIAs) were created due to the persisting low interest rate environment that made it difficult to get meaningful potential interest from existing fixed index annuity crediting methods.

Different reasons for vol-control: Securities vs. FIAs The 1990s were a period of strong market returns and low volatility. The following ten years had multiple periods of high volatility combined with strong market losses. Looking at this period of time, Wall Street created 'what if' models that shifted monies to cash when market volatility was high and into equities when volatility was low. What the models showed was that acting on changes in volatility would have preserved -much of the gains and caused the severe losses to be more moderate in these index/cash combinations. This led to the creation of volatility controlled indices to be used as a risk management tool for securities investors; the volatility control concept received a great deal of attention after the Crash of 2008. In the securities world, vol-controlled indexes are a way to limit losses.

With securities, vol-controlled indexes limit losses. With FIAs, they limit hedging costs.

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DRAFT Vol-Controlled FIA Indices December 2015

The use of volatility controlled indices in the fixed index annuity space was spawned by the protracted very low interest rate environment that has existed since 2011. When 10-year U.S. Treasury rates are under two percent and top-rated corporate bond yields are in the threes, there simply isn't enough yield to provide meaningful participation for an FIA in a traditional index. Volatility controlled indices are 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.

Vol-control indices are a reaction to low bond yields. If bond yields return to the higher levels of earlier years, and option prices remain relatively low, the hedging cost advantage of using volatility control dissipates. Simply put, a vol-controlled index in a fixed index annuity would not be needed if overall bond yields were 3% higher today and volatility remained low. If the annuity pricing environment permits 10% or 12% interest caps and uncapped designs using yield spreads and averaging ? as it did only a few years ago ? you don't need managed volatility to get a competitive return in an FIA (but you would still use it in the investment world to protect against loss). This is not to say issued FIAs using current vol-control indices would become uncompetitive, but that other methods would also be competitive.

What's In A Name Moving from a higher volatility place to a low or no volatility one when volatility spikes is called by different names: Controlling Volatility, Limiting Volatility, Targeting Volatility and Managing Volatility are sometimes used to refer to the same things and sometimes refer to different ones. The possible problem word here is "managed".

If you hear the word "managed" in connection with equities, the mind might make a connection with "manager". After all, there are mutual fund managers and advisors that actively manage money, but managed volatility indices in the FIA space are not actively managed. There isn't a manager waking up one morning and moving from equities to cash because his gut is telling him to, nor is another manager selling one stock within the index and buying another because she has a hunch. Instead, all of these indices are rules-based. What that means is portfolios are rebalanced and positions moved between high and low volatility choices based on prescribed set of rules and not on the decisions of a manager. This is something all of these indices have in common.

When equity index annuities were launched the name became a problem. Index annuities weren't equities, they were fixed annuities, but as soon as people heard the word "equity" they projected all of the good and bad of equities onto the index annuity. However, equity index annuities were never equities (not to be confused with registered index annuities) and yet some regulators jumped on the equities word as evidence they were securities. The solution was a consensus by the industry to refer to these as fixed index annuities.

To avoid any confusion by regulators into thinking that FIA managed volatility indices are in any way similar to managed securities, it might be better to leave the term "managed volatility" to the securities world and avoid it in the annuity one. In this study the concept is referred to as volatilitycontrolled or vol-controlled indices and the actual volatility limits are referred to as volatility targets.

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How It Works

Non-volatility-controlled methods try to lower option costs by lowering the effective participation in the index either by crediting less than 100% of index gains, or capping the gains that will be credited. Both averaging and monthly cap methods use negative volatility as way to limit gains and thus lower the costs of participating in index gains. Another way to deal with volatility is by controlling the exposure.

Controlling Volatility A controlled volatility index approach shifts between an asset class with higher volatility to one with lower or no volatility and then back again. This currently involves moving between an equity index(es) and a bond index or a cash account or between different asset classes. In a non-index annuity setting this approach reduces the probability of big losses. Inside an FIA it reduces the probability of big gains, but still can provide the potential for more interest than through traditional crediting methods.

Volatility Control

Cash (low-vol)

Monies Volatility Target

Equity Index

Volatility

The vol-controlled index has a pre-determined volatility target level; the goal is to keep the overall index volatility at or below the target. The way this happens is when volatility in the equity index(es) begins to climb, money is moved out of the equity side and into the low volatility side. This has the effect of lowering overall volatility ? the greater the volatility, the more that is moved to cash or bonds (the low volatility component). When volatility decreases, the reverse happens with money moving back into equities. This balancing is typically done on a daily basis. The volatility control can be built-into a new index that incorporates high and low/no components, or uses a volatility overlay that can be essentially wrapped around an existing index.

The overall gross return is a combination of the earnings from the equities component and cash/bond component. Some index returns are based on excess returns, meaning this combined return has a benchmark rate deducted (typically the Fed Funds or 3-month LIBOR rate). Today, this benchmark rate deduction is negligible, but it was only a few years ago when this would have resulted in several percent deducted on an annualized basis. In addition, some indices have a service fee (currently ranging from 0.25% to 1% a year) that is also deducted daily on a prorated basis. The [net*] daily returns are added together and a participation rate and/or spread applied.

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DRAFT Vol-Controlled FIA Indices December 2015

Equities Component Return + Low/No Volatility Return = Daily Return [- Excess Return Benchmark ? Service Fee] = Net Daily Return]

Summed Daily Net Returns ? [Spread or times Participation Rate] = FIA Interest Credited

[*bracketed deductions only apply to some indices]

Volatility Target As I write this volatility target rates range from 4.5% to 10%. A higher target rate does not necessarily result in a higher return. An index with a high target rate may have generally lower volatility and lower returns and one with a low target may bump up against the target rate more often and deliver higher returns. Or, a higher target may reflect a longer reset period ? looking at two years instead of one year. Thus, say, a 6% target may deliver a higher return than a 9% target under identical market conditions. However, if everything about two different indices was identical ? except the target rate ? then the higher target should provide a higher return in rising market

Leverage Some indices permit the use of leverage or increased exposure to the equities side. An example would be in an environment where the volatility was far below the target volatility, the index could recognize 150% of equities movement when volatility is below the target.

Strategies/Underlying Indices There is nothing to stop a volatility-controlled index from using the same indices commonly used with previous FIAs, but only the Standard & Poor's 500 is a familiar face in the vol-controlled space. The new vol-controlled indices are using rule-based indices that base changes in their index composition using momentum of the underlying equities, or looking at high dividend equities, or equities showing lower average volatility, or that appear undervalued based on certain metrics. Some indices include bonds, real estate and gold equities and/or exchange traded funds (ETFs). The one thing they share in common is moving to the low volatility component when volatility increases and back again when volatility falls.

When does the managed volatility concept work best & worst wth FIAs? It works best when bond yields are so low that potential returns from traditional crediting methods are less competitive. When bond yields are low and the pricing with traditional methods results in low caps or participation, managed volatility allows for the potential for higher interest. Managed volatility methods are a creative way to provide more value to the consumer in the current low interest rate environment by effectively raising index participation.

VolControl Indices Are Like Snowflakes: The Levers

Speaking at the 1998 National Association of Indexed Products Conference, an actuary from the North Dakota insurance department complained that it was difficult to compare index annuities because they were like snowflakes with no two being exactly alike. At that time this was an exaggeration, since all but one carrier offered only the S&P 500 and a scratch pad could be used to figure out all of the crediting method returns. However, if you look at more than two dozen vol-controlled indices currently available in the FIA space I believe the snowflake metaphor is apt.

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DRAFT Vol-Controlled FIA Indices December 2015

Let's say we have two fixed index annuities (FIAs) using volatility controlled indices. Both offer a crediting method based on 100% participation in movements of identical baskets of stocks and both use a cash equivalent account to manage volatility. Annuity A deducts a 2% yield spread from the calculated annual gains; Annuity B deducts a 1.5% yield spread. Assuming the index has a gain for the year, which annuity will credit more interest? The answer is it depends on several facts.

Servicing Costs ? As mentioned, some FIA vol-controlled indices deduct a servicing fee that ranges from 0.25% to 1.0% per annum that is deducted daily on a prorated basis; information about the servicing fee is often found in the disclaimer language. If Annuity A does not have a servicing fee, but Annuity B has a 1.0% fee, then the effective deduction from Annuity B gains is the 1.5% spread plus the 1% fee for a total of 2.5% - which is higher than Annuity A's 2% deduction.

Excess Return ? Some index returns are calculated as excess returns, meaning the yield of a predetermined benchmark ? such as the Federal Funds rate or the 3-month Libor or a money market rate ? is deducted from gains. If everything else was equal, but Annuity B was calculated as an excess return, then the net index return would be 0.25% less (if, say, the current Fed Funds rate was used).

Volatility Target ? Volatility controlled indices work by switching from one bucket when volatility is rising to a bucket with less or no volatility and then switching back when volatility falls. If Annuity A has a volatility target of 5.5% - meaning the goal is to keep overall volatility under 5.5% - and Annuity B has a target of 5%, Annuity B could well spend more time during the year in the cash account earning zero or close to zero interest, therefore Annuity A could credit more interest.

Rebalancing Frequency ? Most indices rebalance between the high and low volatility components daily, and some monthly. There are advantages to frequent shifting as well as to infrequent shifting of assets. All this really illustrates is frequency of rearranging the portfolio is another reason why identical looking indices may have different returns,

Annuity A and Annuity B have identical portfolios and both use a crediting method with a 100% participation rate that deducts a yield spread. And yet due to possible factors such as servicing costs, the vol-target level and whether the gain calculation is based on the excess return, the annuity with lowest apparent yield spread could result in less interest credited to the annuityowner.

Levers Of The Snowflake Two indices on the surface may sound identical, but unless you were dig deeply into the lines of print you would never know how different they are. One can find carriers that do use identical vol-controlled indices, where simply looking at the spreads would tell you which could post a higher return, but these are the exception.

Cash vs Bonds ? Volatility control means moving from higher to lower volatility. For many indices the low volatility component is cash, which essentially has no volatility and no (very low) returns. Some use different types of bonds. Neither of these are fungible meaning cash operates differently from bonds. In addition, low volatility, in and of itself, does not mean positive returns.

Using bonds as the low volatility component should result in a higher return than simply using cash, as could using a mix of bonds and low volatility equities. However, if interest rates go up, the bond element could post negative returns and impact any positive higher volatility component gains. If a low volatility equity sector gets crunched there could be a situation where a negative return results. Of course, the annuity is not going to lose money, but the overall return could be impacted.

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