Life insurance companies have been offering 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 made their appearance in the late 1980s with the promise of higher returns from mutual fund subaccounts. 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:

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

But annuities are also one of the most expensive types of investments on the market today and often contain 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 many industry experts and regulators over the years, and their appropriate use is still a major focus of debate in the financial industry.

Do It Yourself
Those who are financially sophisticated enough to understand how annuities are designed can build their own portfolios with individual securities that conceptually duplicate the contracts that are offered by commercial carriers, at least in many respects. First, it is necessary to examine how most annuity carriers manage their own investment portfolios. 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 its customers and the fees and charges that it assesses to insure and administrate these policies. But those who design their own annuity simulation portfolios do not have to pay these costs or meet cash reserve requirements, thus allowing them to retain a much larger portion of the profits from their strategy.

Fixed Annuities
Duplicating the interest paid from a fixed annuity is relatively simple. You can create a portfolio of fixed-income securities of a risk level that you are comfortable with. If you are very conservative, then you can use treasury securities or certificate of deposits, while those with a higher risk tolerance could choose from corporate bonds, preferred stock offerings or other similar instruments that pay a higher rate of interest with relative price stability. (As stated previously, most fixed annuity carriers do this and then pass on a lesser rate of interest to the contract owner and keep the spread in return for guaranteeing the principal and interest in the contract.) (To learn more, check out Explaining Types Of Fixed Annuities.)

Indexed Annuities
Creating a portfolio that duplicates the returns offered by indexed annuity contracts is a bit more complex than duplicating a fixed contract payout. 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 that is received, an insurance carrier may invest, perhaps, $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.

Another $10,000 will be used to buy call options on the underlying benchmark index that the contract uses, such as the S&P 500 Index. 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). But all that the investor sees is that the contract value will grow if the index rises, but will not drop if the index falls.

Of course, most indexed contracts have several limitations on how much profit investors can take; 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, then the carrier will keep any excess growth above the cap level. However, any investor can divide up a given amount of money and buy one or more fixed-income securities that will grow back to the original amount of principal by a set date in the future. Zero-coupon bonds can be good for this, but any type of guaranteed security can serve this purpose. (For that matter, riskier fixed-income offerings could be mixed in here 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 the index of your choosing (in most cases this should probably be a stock index). Of course, a basic knowledge of how options work is required to do this successfully. Those without experience in this area, who would like to try this strategy, will need to hire a stockbroker or investment advisor to do this for them. But this strategy is still relatively simple and can ultimately yield the same results as a commercial contract - except without the caps and many of the other fees and costs that come with these contracts.Those who are willing to practice this strategy can therefore count on moderate to substantial gains over time with little or no risk to principal. (For more help, check out our tutorial on Options Basics.)

Strategy Limitations
Admittedly, 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. However, in order 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 70.5. This portfolio also 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 the interest payments offered by fixed and indexed annuities does have some limitations, but can also be more efficient and thus offer higher returns than commercial contracts will pay. For more information on how annuities work and how you can reap similar investment returns, consult your stockbroker or financial advisor. (For related reading, see An Overview Of Annuities.)