Life insurance companies have long offered investors in America the promise of lifetime income from annuity contracts. The first annuity contracts were relatively simple instruments that paid a fixed rate of interest and then paid out a guaranteed stream of income that the beneficiary could not outlive.

Variable annuities appeared in the late 1980s with the promise of higher returns from mutual fund sub-accounts. Indexed annuities were introduced in the following decade as a way of providing a safe method of market participation for conservative investors.

All types of annuity contracts provide several key benefits, such as:

  • Exemption from probate.
  • Protection from creditors in most cases.
  • Unlimited tax-deferral with no contribution limits (for non-individual retirement account or qualified contracts).
  • Protection from superannuation, or outliving one's income (the contract must be annuitized to do this).

Key Takeaways

  • Annuities are investments that take cash up front and promise a guaranteed income stream later on, often for the rest of one's life.
  • Annuities are often thought of as an expensive type of investments up-front, containing a sales fees, charges, and other costs.
  • Most carriers invest cash reserves in a conservative combination of stocks, bonds, and cash that allows the company to meet its financial requirements and still make a profit.
  • Duplicating the interest payments offered by fixed and indexed annuities does have some limitations, but can be more efficient and offer higher returns.

But annuities are also one of the most expensive types of investments, often containing a plethora of fees, charges, and other costs that can substantially reduce the amount of income and principal within the contract. The high expense ratios of many of these contracts have drawn widespread criticism from industry experts and regulators over the years; annuities' appropriate use is still a major debate in the financial industry.

DIY

Those financially sophisticated enough to understand how annuities are designed can build portfolios with individual securities to duplicate the results of annuities offered by insurance carriers, at least in many respects.

First, examine how most annuity carriers manage their own investment portfolios (an annuity's prospectus will generally contain more details about investments of the annuity). Most life insurance carriers invest their cash reserves in a relatively conservative combination of stocks, bonds, and cash that will grow at a rate that allows the company to meet its financial requirements and still make a profit. Of course, these reserves come from the premiums paid by customers and from fees and charges that it assesses to administrate these policies. Those who design their own annuity-simulation portfolios do not have to pay these costs or meet cash reserve requirements, allowing them to retain a much larger portion of the profits.

Fixed Annuities

Duplicating the interest paid from a fixed annuity is relatively simple using a portfolio of fixed-income securities of whatever risk level is comfortable. Conservative investors can use U.S. Treasury securities or certificates of deposit; those with a higher risk tolerance could choose corporate bonds, preferred stock offerings or similar instruments that pay a higher rate of interest with relative price stability.

(As stated, most fixed annuity carriers do this, pass a lesser rate of interest on to the contract owner, and keep the spread in return for guaranteeing the principal and interest in the contract.)

Indexed Annuities

Creating a portfolio that duplicates the returns offered by indexed annuity contracts is a bit more complex. Indexed annuities are funded by a combination of guaranteed investments such as Treasury securities, guaranteed investment contracts, and index options. For example, for every $100,000 of indexed annuity premium received, an insurance carrier may invest $85,000 in guaranteed instruments that will grow back to the original amount of principal (and perhaps a bit more) by the time the contract matures.

Those financially sophisticated enough to understand how annuities are designed can build portfolios that conceptually duplicate annuity contracts.

Another $10,000 will be used to buy call options on the underlying benchmark index that the contract uses, such as the Standard & Poor's 500. If the index rises, then the calls will rise proportionately (but at a rate much greater than that of the index itself due to their speculative nature). The remaining $5,000 may be used to cover contract expenses or other costs, such as the commission to the broker. All that the investor sees is that the contract value will grow if the index rises but will not drop if the index falls.

Most indexed contracts have several limitations on how much profit investors can make; most contracts now have caps over a certain time period, such as 8% per year. This means that if the index rises by more than that amount, the carrier will keep any excess growth above the cap.

But any investor can divide up a given amount of money and use a portion to buy one or more fixed-income securities that will grow back to the original amount of principal by a set future date. Zero-coupon bonds can be good for this, but any type of guaranteed security can serve. (For that matter, riskier fixed-income offerings could be mixed in to beef up the rate of return, depending upon the investor's risk tolerance and time horizon.)

The remainder of the money could then be used to buy calls on a chosen index (in most cases, this should probably be a stock index). Of course, a basic knowledge of options is required. Those without experience in this area will need a stockbroker or investment advisor.

Still, this strategy is relatively simple and can ultimately yield the same results as a commercial contract, without the caps and many of the fees and costs.Those willing to practice this strategy can count on moderate to substantial gains over time with little or no risk to principal.

Strategy Limitations

These portfolios will not be able to provide the insurance protection found in commercial contracts, such as a guaranteed income stream that cannot be outlived. To receive this kind of protection, the investor must annuitize the contract, which surrenders control of the contract to the insurer in return for an irrevocable payout of income for life.

For this reason, the majority of annuity owners choose other forms of payout, such as systematic withdrawal or a required minimum distribution payout at age 70 1/2. Also, this portfolio will not grow tax-deferred like its commercial counterpart unless it is done inside a Traditional or Roth IRA, and many IRA custodians do not permit the use of options in their accounts. Those who wish to employ this strategy inside an IRA must therefore find a self-directed IRA custodian that can facilitate options trading.

The Bottom Line

Duplicating interest payments of commercially available fixed and indexed annuities does have some limitations, but can also be more efficient and offer higher returns than commercial contracts. For more information on how annuities work and how you can reap similar investment returns, consult your stockbroker or financial advisor.