First, to put it on the table, I have a strong bias against EIAs because I think there are more effective ways to achieve the same result.  They often have many moving parts that can make them less valuable than they originally appear and which help hide the expenses built into the product – commissions (often around 8%) and profits for the insurance company.

To show you alternatives that I prefer let me give you two scenarios that achieve similar goals.

If we can earn a little over 5% relatively safely then over seven years we can grow $70 to $100.  So that means if I put $70 in that safe investment I am guaranteed my principal back (i.e., $100) in seven years and I can put the remaining $30 in a index fund.  If you then make the assumption that in 7 years the index fund would never drop more than 75%, you can actually up the index fund allocation to $40 with $60 going into the safe asset.

The advantages this structure provides is no return caps, you receive dividends and you can diversify the equity side (think international and REITs) and tilt it towards small and value to improve your expected return.  In the worst case, if your index funds do drop by 75 percent at the end of seven years you will have your original principal plus the dividends over the seven years which would likely work out to an annual return of 1% to 2% depending on the mix of assets.  In the case of equities returning the historical geometric average of 10% a year, this combination would provide an overall portfolio annual return of around 7.6%.

This approach historically does better more often than the crediting methods used by EIAs.  And in case you have’t noticed, the above description is a pretty close approximation to a 40% stock, 60% bond portfolio.

Now it is also possible to duplicate the crediting methods of an EIA as well.  This is the second scenario I will cover.

To duplicate the point to point EIA crediting method, you would buy a bond/cd/fixed annuity that pays interest keeping a little less than one years worth of interest separate.  Using the money not invested in the bond, you buy a call option with a strike price just above the current market price and sell a call option with a strike price at the cap you desire.  The lower the cap the higher your effective participation rate will be.

Let me show you how that would work with real numbers (prices from October 9th).
SPY (S&P 500 ETF) price: $95.97
Buy Call option for Sep 09 with strike price of $96: $12.30
Sell Call option for Sep 09 with strike price of $105: $7.60
Net cost: $4.70
Interest rate on 7yr vehicle: 5.4%

This would give you participation rate of 100% and an annual cap of 10%.  As you raise the cap (i.e., sell a call option with higher strike price) it would lower the participation rate.  Next September when the options expire, you buy and sell new call options which will cause the participation rate and rate cap to change depending on current option pricing.  Insurance companies are doing the same thing which is why most point to point EIAs have variable participation or rate caps.

So you can effectively duplicate an EIA without all the added costs an insurance company will add which should translate into higher participation rates and caps over the life of the investment.  One thing to be wary of is that insurance companies can offer a teaser participation/rate cap, and then after a year adjust them downward to make sure they make the necessary profits.

With TIPs rates now reaching 3%, I see little reason people need to be aggressive with their portfolios.  As I’ve shown, a conservative portfolio can easily provide the safety an EIA provides.