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Managing volatility for more predictable performance

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Fixed indexed annuities (FIAs) offer customers the opportunity to earn interest credits based in part on the performance of a market index. Increasingly, today's index designs include volatility control mechanisms that seek to produce more stable returns over time. This design can be very beneficial, especially during times with market volatility.

Think of an index as a measuring stick, measuring the performance of a market. Market volatility — positives and negatives — is often viewed as a day-to-day occurrence that affects an index, but another important viewpoint for volatility is the width of index fluctuations over time. This later viewpoint is what affects the performance within FIAs.

A volatility controlled index generally strives to achieve a target volatility level by managing exposure to an underlying index of securities. Volatility control mechanisms are rules-based, meaning they are data-driven and do not rely on emotion or hunches. The objective, broadly speaking, is to produce more stable performance.

How it works

For example, consider a fairly typical volatility controlled index with a target volatility of 5 percent. If measured volatility in the underlying index exceeds 5 percent, the volatility control mechanism reduces exposure to the underlying index. Often this is accomplished by simultaneously increasing exposure to some stable asset, like cash or bonds. If volatility falls below the target level, exposure to the underlying index increases, and exposure to the stable asset decreases.

There are several important things to consider in a volatility controlled index. One is the makeup of the underlying index. Another is the design of the volatility control mechanism. A third is the frequency and nature of any rebalancing in the underlying index. This may include volatility-driven changes in the composition or weighting of the securities in the index.

The benefits of managing volatility

Unexpected economic changes and market volatility can certainly be worrisome. While the market's ups and downs cannot be controlled, volatility control mechanisms strive for more stable performance. This may reduce the carrier's cost to provide its guarantee of protection from loss due to market downturns, in turn enabling higher customer participation in any positive index performance. Generally speaking, the more volatile the index, the more expensive it is to provide that important guarantee.