Would you like an investment that pays gains based on
the stock market, yet helps protect your principal when
the market declines?

Such marketing claims are produced by insurance and financial companies.  The product that satisfies this claim is called an equity indexed annuity (EIA).  When the market rises, the value of the EIA rises; when the market falls, the EIA is protected.  However, what seems like a “win-win” scenario is really a combination of financial products with various fees that are embedded in the final product—which normally go unnoticed by the consumer.  Caveat emptor.

For the above claim to be true there must be some tradeoff between principal protection and upside participation.  In addition, the company that brokers such a product must also profit.  This can be accomplished in a few ways, depending on how the EIA is set up.

One way is to return only a portion of the index’s return; the term for this is called participation rate.  For example, if the participation rate for an EIA is 90%, and the index to which the EIA is linked appreciates 10%, the EIA will only appreciate 9%.  The 1% difference went toward purchasing principal protection (that was never used) and to the insurance company that sold the EIA.

Another possibility is for the buyer to pay a steep, up front commission for the EIA.  I would expect commissions to be around 7-10% of the principal, and I have read of commissions up to 16%!  Imagine spending $11,600 on something that is only worth $10,000!

So what makes an equity indexed annuity?

 The equity indexed annuity is really just a combination of a bond and options that forms a structured note (here, EIA and structured note are used interchangeably).  If the market falls, the structured note returns the principal of the bond plus interest; the upside option has gone unused.  If the market rises, the structured note returns the principal plus upside appreciation, but the participation rate can skim profit.  Either way, the buyer has to forgo something.  Breaking down the structured note reveals that the “win-win” claim is really a “not lose-partially win” phenomenon.

Consumers will generally be better off just purchasing a bond and call option individually from a discount broker.  The payout effect is similar, and commissions will be noticeably cheaper, 1-3%.


Bonus material…

Structured notes can be compiled using various levels of principal protection (full, partial, or none) and upside participation (limited, unlimited, or levered).  Here is a graphic display of a partial principal protected note with levered upside.  The payouts are as follows:

  • If the market appreciates, the note owner receives double the appreciation up to a maximum gain of 20%.
  • If market falls, the note owner does not lose any principal on the first 10% decline.  Market losses in excess of 10% will then be matched dollar for dollar.

This (green line) payout can be accomplished by purchasing a bond, selling a put option and purchasing two call spreads.  (Selling the put option provides funding for purchasing the call spreads).

Thanks to my friends at Columbia Business School for showing me this last example.

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