Thinking of an indexed annuity? Why not just build your own?

6a017c332c5ecb970b019103500289970c-320wiYou’ve heard the annuity pitch.  It says you can participate in market gains while being protected against loss!    But do you really need to buy an annuity to do that?

To paraphrase Warren Buffett, there may be just too many mouths to feed between the investor and the investment; and all those mouths cost money.

Insurance companies don’t have a special market to invest in.  They have to access the same markets you do; so, why pay them to do what you can do yourself?

This is a nifty little strategy I learned when I first entered the investment business more than two decades ago.    In all fairness, there may be one reason to purchase an annuity, but I’ll get to that later.  For now, here’s how you can create your own.

Let’s say you’d like to invest $100,000 for ten years.   You’re willing to pursue a strategy that allows you to invest some of it in the market, but you want a guarantee that ten years from now, you won’t have a loss.

So, first, as I write this, the 10-year U.S. Treasury is yielding 2.19%.  You can check current rates now.

What amount do you have to invest in 10-year Treasuries today at 2.19% so that the bonds will mature at $100,000 ten years from now?  According to my trusty HP-12C, it’s $80,522– I won’t bore you with the pennies.  We’ll put the remaining $19,478 into stocks or something that replicates an index, like an S&P 500 Index fund or ETF (you can’t invest in an index itself).

Of course, anything can happen in the stock market.    Here are three hypothetical outcomes – the real world is bound to be different (it always is):

  1. You lose half your money.  You get $9’739 back from your stocks and $100,000 from your treasury for a total of $109,738.   Not very good, but at least you have your money with a little profit.
  2. Your stocks go nowhere.  You end-up with $100,000 from your Treasury and $19,478 in stocks:  Total:  $119,478 .  Still not great, but you did average 1.8% per year on your money.
  3. Your stocks go up.   Let’s assume 9% a year – an assumption everyone on the planet thought reasonable until the `meltdown’ of 2008 destroyed all the averages.   At that hypothetical rate –  not unreasonable, but who can predict? – you’d end-up with $46,111 in stocks to add to your $100,000 in maturing Treasuries.    Total: $146,111 – an average annual compounded return of 3.86% on the total portfolio.

Not bad, considering you’ve eliminated your risk of loss!

“But Jim”, you say, “Annuities are tax-deferred!”

Yes,they are.  But, when you take your money out, it’s taxed at ordinary income tax rates!    Stock dividends get favorable tax treatment.   Not only that, but if you die first, the cost-basis is stepped-up for your heirs so they don’t pay tax on all previous gains.   And, if you need your money earlier, there are no surrender charges!

How about the insurance company guarantee?    I like the Treasury `guarantee’ better –  I use quotes only because the word `guarantee’ doesn’t appear anywhere on a Treasury or any other government note, bill, or bond.  The wording is, `backed by the full faith and credit of….’.   Nevertheless, it’s a better guarantee.  We’re not Greece, yet.  Remember, an annuity is basically an insurance company’s I.O.U.

The strategy and figures discussed above do not take into account taxes or inflation – the latter being the huge, hidden tax ignored by too many people.   So, you shouldn’t pursue this, or any other, strategy without discussing this with your advisor first.

Why would someone want to buy an annuity when they could just do it on their own? 

The insurance company will  stick with the ten-year plan.  Often the investor won’t.  Many  investors often lack the  discipline to stick with it a long-term process, especially if other more appealing-sounding alternatives grab their attention, particulary as surrender charges reach lower levels.

The drawback:  Investors shouldn’t purchase anything unless you know how it fits-in with an overall plan!    When it comes to comparing strategies, it’s the after-tax and after-inflation dollars – when the money is needed –  that counts.

Plan wisely!



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Jim Lorenzen is a CERTIFIED FINANCIAL PLANNER® professional and An Accredited Investment Fiduciary® in his 21st year of private practice as Founding Principal of The Independent Financial Group, a fee-only registered investment advisor with clients located in New York, Florida, and California. He is also licensed for insurance as an independent agent under California license 0C00742. IFG helps specializes in crafting wealth design strategies around life goals by using a proven planning process coupled with a cost-conscious objective and non-conflicted risk management philosophy.

The Independent Financial Group does not provide legal or tax advice and nothing contained herein should be construed as securities or investment advice, nor an opinion regarding the appropriateness of any investment to the individual reader. The general information provided should not be acted upon without obtaining specific legal, tax, and investment advice from an appropriate licensed professional.