We Went to a Steak Dinner Annuity Pitch. The Salesman Wasn’t Pleased. (55, years)
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"In short (and short is hard when trying to break down products like these), equity indexed annuities tend to work something like this: You hand over a sum of money to an insurance company for a period of time, and at the end you are guaranteed to get at least that much money back if you don't take some money out along the way. You generally don’t get a monthly check, and you agree not to take large amounts out during that period unless you are willing to pay a penalty. As for that equity index part, the insurance company will generally add money to the amount you initially plunked down, providing a portion of the gains reflected in whatever stock index the insurance company is using."
"To learn more about the chart in the pamphlet, I contacted the annuity company that created it, American Equity Investment Life Holding Company.
I asked Steven D. Schwartz, vice president of investor relations for the company, why the chart doesn’t show the returns for the S&P 500 with reinvested dividends. He said it was because the point of the chart is to show the lack of volatility of an equity indexed annuity compared with the S&P 500.
Of course, showing the S&P 500 with reinvested dividends would also do that."
equity indexed annuities are really money markets / cd's on steroids . they are more a proxy for fixed income then for a stock investment because of how they work .
i used to roll my own cd's linked to the markets and do the same thing . they can add alpha to your fixed income .but they are never an equity proxy.
they have nothing in common return wise with equities in fact right off the bad they do not include dividends which accounts for 25-33% of a total retun ..that is because options don’t pay dividends not some trick by the insurer
Last edited by mathjak107; 12-01-2018 at 09:25 AM..
This is not intended to be investment advice. Everything described herein has significant risks, including, but not limited to market risk, default risk, tax risk, the possibility that you will screw up the trades, etc. Please consult your advisor and/or due your own due diligence before making any investment whatsoever..
What is an EIA?
An EIA is an insurance contract that theoretically offers the buyer the opportunity to participate (to some extent) in equity market performance while guaranteeing a minimum payout at the end of the policy guarantee period. The extent to which the buyer participates in equity market performance typically varies year to year as does the minimum guaranteed crediting rate (AKA interest rate paid on the policy). This has proven to be a tantalizing pitch for many conservative investors. The problems with these policies are that you have little control over how much you participate in the equity market; the policies typically have high early surrender fees and very lengthy surrender periods (10+ years is not uncommon); the internal expenses of these policies are quite high; you are exposed to insolvency of the issuer; the participation is typically limited to price changes in an equity index, with no compensation for dividends on the index; the participation in the index is capped at a predetermined level so that really big gains are truncated within the annuity structure; and the tax treatment of eventual distributions may be less than optimal.
How you can “roll your own” EIA, part 1:
By far, the simplest way to set up an EIA is to do it in an uncapped version. The simplest uncapped replication portfolio consists of a 1 year fixed income investment (such as a CD) and a call option on whatever equity index ETF you want exposure to. So let us assume you can buy a 1 year CD that yields (APY) 4%, you want exposure to the S&P 500, you have $100,000 to invest, and you want a minimum yield of 1%. To replicate an EIA, you would buy the following:
CD: You want $101k in a year, so you invest $101,000/1.04 = $97,115 in a 1 year 4% yield CD. In a year, the CD matures and you get $101,000, which is your desired minimum payout.
Options: Your CD purchase leaves you with $100,000 - $97,115 = $2,885. You take this amount and buy at the money 1 year call options on the S&P 500 index ETF (ETF symbol SPY). At the money means that the option exercise price is about equal to whatever the ETF sells for today. So with SPY trading at $137.93 as I write this in April 2008, we wish to buy April 2009 calls with a strike of $138. Such a thing doesn’t exist, so we will settle for the closest month we can get, which is March 2009. March 2009 calls (Symbol SFBCH) sell for $12 each and must be bought in contracts on 100 shares each, so you want to buy $2885/$1200 = 2.4 contracts, but must buy 2 contracts for $2400.
So you end up with a CD that will pay $101,000 in a year, $485 in cash, and options on 200 shares of SPY struck at 138. The options cover a notional amount of $138 X 200 = $27,600, so your “participation rate” in the index is 27,600/100,000 = 27.6%, meaning that you catch 27.6% of the appreciation of the S&P 500 through next March while bearing none of the downside. When the options are about to mature, you can sell them for cash, assuming the market has gone up and they are worth anything. Otherwise, you collect your $101,000 from the CD, have your $485 plus whatever interest it generated, and decide if you want to play this game again for another year.
Rolling your own, part 2:
Instead of having a small, uncapped participation in the index, you could have a larger participation but cap it at a given level. This is essentially what is done inside the EIA contract sold by most insurers. To replicate the EIA, you would buy the same CD as in the above example. However, the options portion would include:
1) Buy the at the money options on the index as in the above example
2) Sell out of the money options for the same expiration date and underlying ETF.
An example will be helpful:
Lets assume that you would be willing to cap your upside in return for a higher participation rate. That means you want to buy call options at the money ($138 strike) and sell call options at a strike that is about 10% higher ($152 strike). The $152 strike options currently trade for about $5.50 a share. So we buy:
4 contracts of the at the money options (SFBCH) for 400X12 = $4800
And we sell:
4 contracts of the 10% higher strike $152 (symbol SYHCV) and receive cash of $400X5.50 = $2,200.
Total out of pocket for the options is $4,800 - $2,200 = $2,600.
So you end up with a portfolio that consists of a CD that will pay you $101,000 in a year, $285 in leftover cash, and a package of options that gives you up to 10% of the upside on 400 X $138 = $55,200 worth of the S&P 500 index. Note that by capping your potential upside you have increased your participation rate to $55.2% of your $100,000, or double the uncapped version.
About taxes:
If this is done in a taxable account, the CD interest will be taxable and so will the gains or losses on the options. In this case, you would want to set up the portfolio for at least 1 year and 1 day to qualify for long term cap gains on the options. So instead of buying a 1 year CD, perhaps you would buy an 18 month CD and options that expired in 18 months. Inside an IRA or other tax sheltered account this would be of no concern, but your broker may not allow you to set up the capped EIA replication inside an IRA.
Other odds & ends:
- I have ignored transaction costs here. The CD should cost you nothing. Most discount brokers will charge less that $20 for an option trade.
- Brokers generally require customers to apply for approval before they can trade options.
- Note that you can buy options on any index you like that has an ETF with options traded.
"In short (and short is hard when trying to break down products like these), equity indexed annuities tend to work something like this: You hand over a sum of money to an insurance company for a period of time, and at the end you are guaranteed to get at least that much money back if you don't take some money out along the way. You generally don’t get a monthly check, and you agree not to take large amounts out during that period unless you are willing to pay a penalty. As for that equity index part, the insurance company will generally add money to the amount you initially plunked down, providing a portion of the gains reflected in whatever stock index the insurance company is using."
"To learn more about the chart in the pamphlet, I contacted the annuity company that created it, American Equity Investment Life Holding Company.
I asked Steven D. Schwartz, vice president of investor relations for the company, why the chart doesn’t show the returns for the S&P 500 with reinvested dividends. He said it was because the point of the chart is to show the lack of volatility of an equity indexed annuity compared with the S&P 500.
Of course, showing the S&P 500 with reinvested dividends would also do that."
The "free" steak dinner isn't
Caveat Emptor
Did the talking head happen to mention what the annual fees for this Annuity were.
They surely would take a bite out of your returns.
they never tell you at a presentation , you have to dig ..... there really is not much " market " return when all is said and done . between almost 1/3 of the markets returns being immediatly removed because of no dividends , expenses and the various caps on participation it is really a glorified fixed income investment .
you can see above how it really is fixed income based and then linked to options for a bit of a market participation ..
If you want the dinner, all you need to do is politely decline, then get rougher if pushed.
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