What IS an Annuity?

Apologies to the Dowager Countess for my heading in response to index-linked annuity advertisements that creep up like weeds whenever the stock market falls.

I believe these ads mislead and are harmful to your wealth. The above is a rough picture of the investment portion of a one year index-linked annuity contract. These expensive and opaque insurance contracts generally offer, for a 1, 3 or 6 year term, a certain amount of "protection" or "shield" from market declines along with a capped share of the gain if the market rises.

This "insurance" strategy can easily be created with exchange traded index options with total transparency, total liquidity, at extremely low cost with NO withdrawal fees and a far smaller margin deposit than any insurance purchase.

The SPY, S&P 500 ETF, chart above shows the profits and loss from a "split strike with short put" options strategy.  It's very much like the "split strike" strategy touted by Bernie Madoff but without the upside.  Whether Madoff is a tip off or not, this is the terrible strategy:

As of today's closing prices, with SPY at 290, (1000 shares = $290,000),
Buy 10 SPY June 2020 (1-year) 290 (at-the-money) Puts for roughly $18.30 or $18,300
Sell 10 SPY June 2020 260 (10% out-of-the-money) Puts for $9.50 or $9,500
Sell 10 SPY June 2020 320 (10% in-the-money) Puts for $35.10 or $35,100

These trades combined will credit your options account with $26,300.
Total commissions at my broker would be roughly $20. No withdrawal fees, no hassle to get in or get out!

This $26K credit is the "protection" against the loss of your real portfolio, which in this example, is the $290,000 invested in the SPY.  This example is slightly less than 10% but you can increase your credit to by adjusting the strike prices of your options.

Why is this strategy so bad? Look at the chart: your losses can be maximized and your gains are limited, the exact opposite what any investor wants. If you really do want protection, forget selling puts and just buy the at-the-money put. This is an insurance policy that costs 6.3% of your portfolio and gives you total protection from the downside with full participation (except for the insurance premium) if the SPY rises.

The chart above is so bad that option traders don't even sell this strategy. You would be hard pressed to find the above options payoff chart online.  Its so bad that only annuity salesmen would sell it.

Feel free to post comments.

Disclaimer: Posts are for education only and not investment advice, may be subject to change without notice, and, while prepared with care, may be subject to omissions and errors.