The next step is to see how upside potential develops through a participation rate. The insurance company can use the remaining funds to buy a one-year at-the-money call option on the S&P 500 index. This is a financial derivative that provides its owner with the right, but not the obligation, to buy shares of the S&P 500 at the option’s strike price. The option is at-the-money if the strike price matches the current value of the index.
Suppose the S&P 500 index is currently at 1000, and the insurance company buys a call option to purchase the index at 1000 after a one-year period. If the index has declined in value at the end of the year, the insurance company will not exercise its option to buy the index at the now higher strike price. The option expires, worthless. With the bond, the contract value was protected at $100 and no additional upside is received because the credited interest linked to the index is $0. This represents the principal protection of the FIA.
However, if the S&P 500 index price has increased in value at the end of the year through capital gains (not including reinvested dividends), then the insurance company exercises the option to buy the S&P 500 at the now lower strike price. What happens in practice is that the shares are not actually purchased, but the call option owner receives a payment equal to the gain in the index relative to the strike price from the seller of the call option. For example, if the index ended the year at 1060, it experienced a 6 percent price return, and this gain is received by the insurance company. The gain can then be credited to the contract value of the annuity.
The assumed $1.96 left in this example is probably not enough to buy a call option on a full share of the S&P 500. Suppose, for example, a one-year call option costs $3.50. In this case, the $1.96 options budget represents 56 percent of the call option price. This means that the index annuity could offer a 56 percent participation rate on the upside from the S&P 500 price return. The FIA could offer a protective floor through bond purchases with the potential to receive 56 percent of the upside growth through the call option purchase with the remaining funds. If the S&P 500 price return was 4 percent, for instance, then the annuity would be credited with a 2.24 percent gain. Owning a bond and a call option on the index allows the insurance to guarantee a minimum interest value while also offering upside exposure to the index.
As an alternative, FIA owners might seek to maintain an ongoing participation rate of 100 percent. One way that this can be accomplished is by introducing a cap on interest that can be credited. To create 100 percent upside participation, the insurance company could also sell call options on the S&P 500 to provide additional funds beyond the $1.96. This would support buying more of the at-the-money call option. In our simple example, to provide 100 percent participation, the insurance company would like to buy a full call option costing $3.50. It needs to raise an additional $1.54 to do this. Call options become cheaper as the strike price increases since the market would need a bigger gain before any payment from the option is due. There will be a strike price that would support call option pricing at $1.54. The key is to find what this value is. It would then serve as the cap for the current term of the FIA. The insurance company sells a call option at a higher strike price to raise additional funds in order to buy a full at-the-money call option.
By selling the call option, the insurance company is then on the hook to pay any gains on the index above that strike price to the buyer of the option. Suppose a one-year out-of-the-money call option with a strike price of 1060 is the right level so that the option price is $1.54. The insurance company could sell one call option with the 1060 strike price and then buy the full call option with the strike price of 1000. Then, any gains between 0 percent and 6 percent can be accrued to the contract value with full 100 percent participation. But the gains are capped at 6 percent because any return above that reflects an obligation the insurance company must pay to the owner of the call option it sold.
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A subtle detail that must be emphasized is whether the cap is an interest cap or an index cap. I have been describing an interest cap, which is more advantageous to the consumer, assuming everything else remains the same.
With an index cap, instead, the amount of the index gain realized is capped before then calculating the amount of interest applied. For instance, suppose an FIA has a 50 percent participation rate and a cap of 10 percent, and the index return is 25 percent. If that cap is an interest cap as we have been assuming, the total interest credited is calculated as 50 percent of 25 percent, which would be 12.5 percent, but it is capped at 10 percent. However, if the FIA instead has an index cap of 10 percent, then 10 percent of the gain is realized for determining interest. With the 50 percent participation rate on the 10 percent index gain realized, credited interest is only 5 percent. This makes a difference and it is important to understand which method is used by the insurance company.
This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon
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