Volatility Controlled Annuity Indexes
Anyone who owns or is considering buying a fixed indexed annuity needs to understand this post. Hundreds of people have come to me after buying an annuity asking why they aren’t earning as much as they had been promised. I sold some of these too but never with outlandish expectations. I heard from a new person last week who had been promised 10-12% but after two years was only averaging about three percent. One look at the contract and I could tell that what he earned in interest was about what he should expect. The contract was doing fine but he had been promised much more.
For the purpose of this letter and others similar I’m going to make this disclaimer: I am not talking about all agents and financial advisors who sell annuities. Clearly I only hear from clients of salespeople who don’t know what they are doing. Clients of good advisors are getting the answers they need and obviously don’t need to seek explanations from other professionals.
Agents kind of disappear when this happens and the guy who called just needed some advice. He never should have bought the contract with such high expectations but the agent didn’t properly explain it. The agent just went for a big sale with sky high expectations and wasn’t around to service the account just two years later. For now let’s avoid sharp criticism because I know how this happens. The agent trusted the wrong person and didn’t do his homework. It happens to all of us and my first bad experience came shortly after I started the website. I lost sales because of it but I never put a consumer in a bad contract.
Back in 2015 or maybe a little earlier, insurance companies introduced blended indexes to fixed indexed annuities. They were new and different and most people had never heard of them. It started because rates were really low and options on the S&P 500 were expensive, leading to really low cap and participation rates. Volatility controls on blended indexes created slower moving index values and more consistent pricing on options. An insurance company could put a high cap or participation rate on a blended index that looks like a really good deal. Participation rates of 100% or more made consumers feel as though they had a no risk way of matching market returns. It couldn’t be further from the truth.
Risk controlled indexes need to be explained in more detail and the sales literature from the insurance companies only scratches the surface. The idea is to limit volatility in the index by using a cash/bond component, similar to a blended investment portfolio. Most of these indexes use bonds or treasuries for the cash component, meaning that fluctuations in the value of those assets will affect the index return over time. We talked about bonds last week and the same principle holds true here. If the safe side of an index can lose money then total returns are not so simple as just watching the market. You have to worry about interest rates too.
When volatility in the market is high, the index shifts money to the safe side to limit downside risk. It also limits upside growth because volatility is also high when the market posts some of its biggest returns. The index may keep assets out of a falling market but in doing so is exposed to fluctuations in interest rates. Now you have two variables that either limit or enhance performance. It is the behavior of the bond side that is rarely explained and a lot of the time that makes up the largest allocation in the index.
Risk control factors are the final piece of the puzzle. Everyone asks what it means when they see an index named something like “XYZ Equity Max Risk Control 5%”. A lot of times the name is just fluff and you need to focus on the risk control number. That is the target amount of volatility for the index. Stock exchanges continually calculate the level of volatility present in the market and express it as a percentage. The VIX is a volatility gauge for the S&P 500 run by the Chicago Board of Exchange and it is the most widely used indicator I know. Let’s say the VIX is showing 20% volatility and you have an index with a 5% volatility target. That means that only one quarter of the index will have exposure to the equity or stock side. The rest will be sitting on the bond side, which means that your returns will more closely resemble a bond portfolio than a stock portfolio.
When you put it all together and do a little thinking then it starts to make sense. These indexes were all created recently and have no real track record. The historic performance you see is backtested. Yes, they assumed the index was operating in the past and projected hypothetical performance. That ain’t worth the paper it’s printed on because I could backtest $1000 to last week and have a million dollars now. Knowing that you have an often limited exposure to stocks and a forced bond allocation, you need to know how both of those performed in the past to take a guess as to whether economic conditions will repeat themselves in the future.
Companies are now running illustrations that go back 15 years for hypothetical numbers. What did we have during that time? We had high volatility, an exploding stock market, and consistently falling interest rates. Past performance, which wasn’t even real, was enhanced by increasing bond values. If those conditions don’t repeat then you aren’t going to have yields anywhere close to what was projected on the illustration. For the past three years we have had more or less steady rates, high volatility, and a good stock market. High volatility means very little of these indexes was allocated to the stock side and flat rates means that the bond side didn’t do a whole lot. So, the indexes fell flat and everyone that bought with high expectations is wondering how it happened.
This is not to say that you should avoid these indexes altogether, although a simple S&P 500 allocation will do just fine for you. Rather, understand the conditions required for success and only use it when the outlook is promising. Ideal conditions would be low to average volatility in the stock market and static or slightly falling interest rates. If you have a sharp drop in interest rates then you might see big yields and that happened in the Covid crash. Interest rates dropped to nearly zero in a short period of time and a lot of the volatility controlled indexes increased in value substantially. Now you know how that happened.
Many of the available blended indexes use a 5% volatility target but some use volatility targets up to 12%. The more volatility allowed then the higher returns you can expect. The lower volatility indexes should be used for conservative projections. You might have a big year here or there but don’t even expect it to happen ten years in a row like the illustrations suggest. Do your homework and ask difficult questions of any salesman you meet. If he gets defensive then you should probably go work with someone else. Get on my calendar if you want to talk straight.
Have a great weekend!
Bryan
Watch Episode 211: Volatility Control Indexes on Fixed Index Annuities
Last Updated on January 22, 2026 by Bryan Anderson
