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brewer12345

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Click HERE for instructions on how to replicate an Equity Indexed Annuity!

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A word of caution:

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. YMMV, E Pluribus Unum, Ramen.

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.
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CharlesSchwab

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Source LINK.
 
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Participation in market performance with guaranteed minimum growth

Looking for a retirement savings vehicle offering you higher earnings if the market goes up, yet guaranteed growth even if it doesn't? An equity index annuity from Schwab may be the answer. Index annuities let you participate in the potential growth of an equity index while protecting your savings with minimum guaranteed earnings.2 This makes them ideal for people who want to participate in the market performance upside without exposing their retirement savings to downside risk.

How do index annuities work?
You purchase an index annuity contract with a single premium payment. Earnings are linked to a formula based on changes in select equity indexes. If the index goes up, you share in the gains, up to the annual interest rate cap. If the market goes down, you're protected—your principal and credited interest can never decrease due to market declines.

Get the best of both worlds.
Index annuities are appealing because like traditional fixed annuities, your principal and credited interest can never decrease due to market declines, with all interest tax-deferred until you make withdrawals. However, index annuities also offer the opportunity for higher returns than many bank or traditional fixed rate vehicles by linking the interest rate to certain equity indexes. Then, when it's time to receive a payout, you can choose from a variety of options to set up a reliable stream of retirement income.3

For clients looking to benefit from the performance of leading market indexes while guaranteeing principal protection plus minimum growth, Schwab offers a five-year contract. Choose either the S&P 500® or the Dow Jones Industrial AverageSM as your benchmark.
 

1. Charles Schwab & Co., Inc., a licensed insurance agency, offers annuity products that are issued by non-affiliated insurance companies.

2. Guarantees are subject to the claims-paying ability of the insurance company and surrender charges may apply if money is withdrawn before the end of the contract. Market performance participation is typically subject to a cap.

3. All withdrawals of tax-deferred earnings are subject to current income tax, and, if made prior to age 59½, may also be subject to a 10% federal income tax penalty.
 
Spicuzza

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brewer12345 wrote:

Quote:

A word of caution:

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.



Hmmmmmmmmm, you forgot to mention there is ZERO risk of loss of the client's money in an Equity Indexed Annuity, technically called a FIXED Indexed Annuity.

So your instructions on how to replicate a Fixed Indexed Annuity are flawed from the very outset.

You don't know what you're talking about.


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Gary D. Spicuzza,
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