Build Your Own Annuity

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

Variable annuities gained popularity 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:

  • Exemptions from probate
  • Protection from creditors in most cases
  • Unlimited tax deferrals with no contribution limits (for non-individual retirement accounts 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, often accompanied by a plethora of fees, charges, and other costs that can substantially reduce the amount of income and principal promised by the contract. The high expense ratios of many of these contracts have drawn criticism from industry experts and regulators over the years. That said, the appropriate use of annuities is still a major debate in the financial industry.

Key Takeaways

  • Annuities are investments that take cash upfront and promise a guaranteed income stream in the future—often for the rest of one's life.
  • Annuities are often considered to be expensive investments upfront, containing 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.
  • You may be able to duplicate the interest payments offered by fixed and indexed annuities with a little work.
  • Keep in mind that there are certain limitations if you adopt this strategy, which may be more efficient and offer higher returns than other investments.

Do-it-Yourself Annuities

People who are 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. You can find this on an annuity prospectus, which will generally contain more details about how the annuity is invested. 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.

If you invest in an annuity and die before the benefits kick in, your beneficiary is entitled to receive a payment.

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.

Most indexed contracts have several limitations on how much profit investors can make. As such, 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 their principal.


Let's take a look at how indexed annuities are invested. 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
  • 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.

Strategy Limitations of Annuities

Before you go out to design your investment, there are a few things you'll need to keep in mind. The portfolios of annuities don't provide the insurance protection typically found in commercial contracts like a guaranteed income stream that cannot be outlived. The investor must annuitize the contract to receive this kind of protection. Doing so surrenders control of the contract to the insurer in return for an irrevocable payout of income for life.

This is why most annuity owners choose other forms of payout, such as a systematic withdrawal required minimum distribution (RMD). This portfolio also doesn't grow tax-deferred unless it's part of a traditional or Roth individual retirement account (IRA). You'll need to find a self-directed IRA custodian if you want an annuity inside an IRA as most custodians don't permit the use of options in their accounts.

How Do Annuities Work?

An annuity is a financial contract between an investor and an insurance company. The investor purchases the contract with a lump-sum payment or regular installments. The insurer agrees to pay the investor a sum of money either in a single payment or over a period of time. This provides the investor with a guaranteed stream of income, which is why annuities are commonly used for retirement purposes. These investments do come with tax benefits—notably, they grow on a tax-deferred basis. But investors are taxed on the income they receive.

How Are Annuities Taxed?

Annuities generally come with an upfront tax benefit. This means that when you invest in one, the money grows on a tax-deferred basis. As such, you don't have to pay any taxes on the interest earned as it grows. The tax, though, is paid when it comes time to take withdrawals. This amount, whether you take it as a lump-sum payment or over time as distributions, is taxed as your ordinary income.

Is an Annuity Better Than a 401(k)?

There's no real definitive answer to this question. That's because it depends on your situation and goals. But it's always a good idea to know what the difference is between the two. Keep in mind that you can choose to invest in either one or both.

An annuity is a contract that you purchase from an insurance company with a lump-sum payment or premiums. In return, the insurer guarantees you a steady stream of income in the future as the earnings grow tax-free. When it comes time for the income to be paid out, you can choose a lump sum or regular distributions. This income is taxed as ordinary income. You can use an annuity for retirement, but it's not necessary.

A 401(k) is an employer-sponsored retirement plan. You contribute to it through payroll deductions and you may also receive an employer match if it applies. The contributions are limited each year. Like an annuity, the earnings grow tax-free until retirement. At this time, you are required to take your required minimum distributions, which are taxed as regular income.

The Bottom Line

Duplicating the interest payments of commercially available fixed and indexed annuities does have some limitations, but the practice 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.

Article Sources
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