Options as Investments
The owner of a call option has paid a dollar or so for the right to buy 100 shares of XYZ corporation’s stock (currently selling at $100/share) from the owner who sold the call option for $102/share at any time within a specified period, such as a year. The buyer knows that in most years the price of XYZ rises at least this much even though it sometimes loses, so doing this over and over again captures long-term price patterns. Now, imagine that the price rises to $105. That call contract could be exercised to buy 100 shares at $102 (a $3/share profit), or it can be sold to someone else for (almost) $105. Selling the call contract is what many investors do, harvesting almost $300 per 100-share contract. The seller of the call would have preferred to have kept all of the $5 gain, but at least the seller locked in $2 of that from the call premium. If the stock failed to rise above the strike price of $102 (or the stock lost value), the call would not be exercised; in that case, the premium would be the most the buyer lost even if the stock price plummeted, and the seller at least got that premium, mitigating some of that stock owner’s downside risk.
A put is the opposite type of contract: A buyer of a put gains the right to sell his stock to the seller of the put at a price a tad below the current price, thus limiting the downside risk for that stock owner; the stock owner paid a premium to assure that the selling price would be no lower than the strike price. There are combinations of these options, and even more exotic contracts, that can be bought and sold on electronic markets; they are used either defensively or speculatively. Understand these if you plan to have a portfolio containing individual stocks and bonds, because these are tools to defend securities value when you have reason to fear excess volatility coming; use these with the counsel of an experienced broker.
Best Annuity?
Prudential Life, a fine insurer, especially for large non-variable whole life policies, offers—even allows to be brokered by competitors—a fascinating variable annuity: the HD Lifetime series of annuities. These annuities have truly outstanding money managers available, and they expertly hire and fire these with diligence and care. This annuity has the highest fees I have seen in variable annuities, but a truly intriguing benefit: Every single day, the market value is recorded and then locked in for purposes of an income account (not a walk-away cash value lock-in). That is, the highest market value is guaranteed to be the “high water mark” from which an annuitant would draw lifelong income. Hence the term HD, for “Highest Daily value,” Lifetime. Some insurers guarantee only the highest market value that existed on any anniversary—Prudential locks in the highest day ever! But there are three catches that I have personally found consumers are not told, though they can find them in the prospectus. First, the management is “cloned” from other famous managers and mutual funds, but the cloned version is far less aggressive than the retail fund or manager, so Prudential dampens the return it must insure (its fees help with that too). Second, when one activates the income rider, the dampening effect on aggressiveness is far greater, but owners may think that their previous level of aggressiveness continues during the payout phase; it is not even close. Finally, the percentage of the insured high market value is lower than most such variable annuities. Is this a deception? Not technically, because reps are not expected to explain every detail; they must disclose the main details and present the prospectus and ask customers to read it.
This ratcheting effect for income riders is a great idea. But let’s examine how this can get removed from the contract. The secret is that most agents do not even know the following unless they read legalese: variable annuity issuers are regulated differently from equity index annuity issuers. VAs are subject to removal of the income rider (carriers can buy it back, like it or not) but equity index annuities issuers cannot.
How These ‘Complicated’ EIAs and EIULs Work
Equity-indexed annuities (EIAs) and the universal life version (EIULs) have their market value guaranteed to never suffer from a market loss. The cash value in both EIULs and in EIAs credit interest based upon the change in a selected index, like the S&P 500 (no dividends) or the Russell 2000 (scant anyway) or your chosen combination. An index is a numerical expression of price level for a given type of stock or bond (e.g., if the price level last year was expressed as 1,000 but it grew 9%, then the index would be 1,090 at the end of that year).
Understanding Limits on Growth
There are limits to how much gain can be recorded for the purpose of calculating the interest you get. Even though EIAs guarantee against market losses, there are no limits on losses that are recorded for the interest formula’s time frame. Contradictory? No. Each month the loss or gain is recorded for purposes of determining the interest to be credited at the end of the policy year; a loss in a month diminishes the interest, but the lowest interest earned is still zero if there were several bad months. There are limits on how much growth in the index can be counted. Changes in the index are tracked monthly if you chose a monthly tracking method (interest is nevertheless credited annually). Changes in the index are recorded only annually if you chose an annual tracking method. So the first choice is annual versus monthly tracking.
There are two variations on monthly versus annual tracking of gains and losses. There is a choice of recording monthly versus annual frequency of the tracked index changes: point-to-point asks, “What is the beginning index value and what is the end-of-policy-year index level?”
The second variation is to average all months by totaling the (countable) index changes for each month and dividing by twelve. “Counted” means there are limits to the gains but no limit to the losses that are in the calculation. These limitations are accomplished through “caps” and “participation rates,” discussed next.
EIAs have caps (the maximum gain that can be considered for the tracked time frame) and participation rates (the proportion of the market index movement that will be counted in your crediting formula). To show one of many possible examples, we’ll look at monthly point-to-point with a cap of 2% and a participation rate of 80%: Your account starts with $100,000. In month 1, the index increased 5% (nice). But your cap is 2. So you get a 2% growth factor for that month. Next month, the index retreats 5%. That month, you get a negative 5. Each month is recorded this way until all twelve months are recorded. The total is tallied, both negatives and positives. If that total is negative, you get no interest for that year but at least you did not suffer the loss that the index suffered. Let’s imagine that the total is 10%. Your participation rate is 80%, so you get 80% of the 10% (counted) growth. Your account is now $100,800 and you can change indexes and crediting methods during a thirty-day anniversary window.
This excerpt is taken from “The Secrets of Successful Financial Planning: Inside Tips From an Expert,” by Dan Gallagher.
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