I’m not much for hype, but there are some really cool financial products on the market, provided you understand the benefits and hazards that come with them. Equity indexed products have the potential to put fixed interest earnings on steroids, if you’re looking for that sort of thing.

Traditionally, there has only been one way to earn interest on your savings (as opposed to investing in the stock market or some other type of variable financial contract): find the highest fixed interest rate you can find, put your money into that account, and hope for the best. It could be a savings account, a bank CD, or a fixed annuity or life insurance. But, this also meant that if you were to buy into any of these you had to accept that fixed rate and no more. If the stock market started doing well, you would have to draw some (or all) of your money out of one of these accounts and place it into a higher risk account.

Today, no such need exists. Innovation by life insurance companies has brought about a concept called “equity indexing”. This relatively unknown and underutilized concept makes it very easy to reap the upside of the stock market without any of the downside risks – all without investing in the stock market. If the stock market gains 10%, so can you. If the stock market loses 10%, not only do you not lose money, you actually make a guaranteed fixed rate of return. How could anyone possibly offer something like this, and more importantly why?

How do companies offer you the upside of the stock market without any of the risks of investing?

The first point that should be stressed is that by using a contract which promises an equity indexing feature, you are not investing in the stock market in any way, shape, or form. You are giving your money to a bank, brokerage house, or an insurance company and in return they are acting as a financial intermediary. In return for buying into such a contract, they are willing to pay you handsomely if the stock market gains value.

Early attempts at equity indexing involved annuities. However, later, this idea expanded to life insurance, bank CDs, and corporate notes. Initially the index that these annuities were linked to were interest rate indices, like the 10 year U.S. treasury note index, rather than an equity index – such as the S&P 500 stock index.

When we are talking about an equity index, all an index represents is a number used to measure the general behavior of stock prices by measuring the current price behavior of a representative group of stocks in relation to a base value. The Dow Jones, for example, measures 30 of the largest and most established companies in America; often referred to as “blue chip” companies. It consists of companies like Walt Disney, Wal-Mart, and Microsoft. The S&P 500, on the other hand, measures 500 large cap companies, most of which are American.

To make an equity indexed contract work, there needs to be two components: bonds (or bond-like instruments) and index call options. A bond is a debt instrument – a loan if you will – made by the Government or a corporation to another party, usually an institution like a bank or a life insurance company. These pay a fixed rate of return. If the bond is going to pay (i.e. if the debtor – the Government or the corporation – does not default on the bond) it will pay the stated interest rate. There is no variance. Government bonds are widely used and deemed to be “good as gold”. Very few individuals or institutions fear that the Government will go bankrupt or be unable to pay the interest on its outstanding bonds.

An index call option is a stock option. A stock option is the right – but not the obligation – to buy or sell stock for a preset price (which is set when the option is purchased). There are two types of options: call options and put options. A put option is the right to sell stock at a preset price, and a call option is the right to buy stock at a preset price. So, for example, if you thought that a company’s stock was set to gain value, but you weren’t 100% sure that it would, you could buy a call option for much much less than buying the actual stock. Essentially, you are able to control a large amount of stock with very little money up front. You don’t actually own the stock and you don’t ever have to buy the stock, which is what gives you protection if the stock doesn’t do as well as you expected. However, there is an expiration for every option. And…the longer the expiration date, the more expensive the option will cost (i.e. a 3 month call option may cost $500, but a 1 year call option may cost $750).

An index call option is a call option on a stock index – usually the S&P500 stock index. Banks and insurance companies are able to use a very precise mix of bonds (to guarantee the contract owner’s principal plus a small amount of appreciation) and index call options (to capture the upside potential of the stock market) to produce a new type of contract that gives the contract owner the upside potential of the stock market, without any of the downside risks associated with a direct investment in the stock market.

To make sure that these institutions have the money needed to credit the promised interest to the contract, the issuing bank or insurance company enters into an agreement to purchase counter-balancing investments (i.e. bonds or bond-like instruments) through what is called a ‘counterparty’ – a company that acts similar to a reinsurance company. The insurance company or bank also purchases the index call options through counterparties to ensure that all of the obligations of the index contract can be fulfilled. This is known as “hedging”.

While equity indexed contracts do provide a guaranteed minimum, the guarantee is usually weaker than in traditional ‘declared rate’ contracts, like bank CDs, but this is because the focus is on the upside potential of the contract. If fixed rates are higher or comparable to indexed returns and you would like to take advantage of fixed rates, some contracts provide the option to switch to fixed rate returns that mirror current bank CDs or annuity contracts.

Insurance companies and banks are willing to offer indexed returns because they are obviously making money with this approach. They can afford to credit you with the interest gains, because just like every other financial product, these contracts also have their own expense and administrative charges.

Should you do it?

If you are considering whether or not you should purchase an equity index contract, consider what you would like to do with the money you have available. If you are more concerned about saving money and protecting your principal, but would like the potential for a more aggressive rate of return on your savings than can be found in ‘declared rate’ products like fixed annuities, bank CDs, or money market accounts, then an equity indexed account might be the very best option for you. I’m not going to lie, they could do better or worse than the declared rate product. That’s a gamble you have to decide that you’re willing to take.

Equity indexed products do not mirror the market exactly. They exclude dividends, which you should consider. They also have “moving parts” that cap earnings, and these moving parts and explicit caps on earnings vary by company. Equity-linked products are not meant to replace an investment in stocks. They are designed as a more aggressive high-yield savings product.

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1. Equity Indexed Annuities Get A Bad Rap, But Do They Deserve It?

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This entry was posted on December 1st, 2011 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Insurance & Savings, Investing, Retirement Planning