How to Build Your Own Equity-Index Annuity

Last month’s visit discussed equity-indexed annuities (EIAs). We reviewed their different elements,  ad-vantages and disadvantages. This month we explain how you can generate very similar results by creating your own EIA.

Remember the attraction of an EIA is you are assured in the worst case of a return of your principal after about 10 years and perhaps a minimum rate of return of 1% to 3%. You have the potential for a higher return if the stock market does well. There’s no magic in how the insurers achieve these results. You may be able to do the same without incurring the costs and limitations of the EIA.

In the past I’ve recommended quality balanced funds as one route to imitate an EIA. Most good balanced funds are diversified between stocks and bonds (usually 60% of one and 40% of the other). This diversification results in few negative return years and a generally positive long-term return.

It was made clear by 2008’s results the balanced fund approach would not avoid significant negative returns during a financial calamity. All of my recommended balanced funds had negative returns of 9.5% or more in 2008, and only Vanguard Wellesley Income investors have a positive return since the peak in 2007. I have little doubt the strategy pays off in the long-term and most market environments. The balanced funds to consider are Dodge & Cox Balanced, Vanguard Wellesley Income, Vanguard Wellington, FPA Crescent, and Oakmark Equity & Income.

You also can consider a hedged or tactical fund such as Hussman Strategic Growth or PIMCO All Asset. We’ve recommended both for years in different portfolios and discuss them regularly in our investment recommendations.

Another approach is to more directly imitate what the insurers would do with your EIA premium.

With the bulk of your investment, buy safe, low return investments that are pretty much guaranteed to pay off in 10 years. You can buy zero coupon treasury bonds or a mutual fund that buys them such as American Century Target Maturity Series 2020. A zero coupon bond doesn’t pay interest. Its market value will fluctuate with interest rates, but at maturity it will pay the face value of the bond. You buy today at a significant discount from the face value, calculated based on today’s interest rates. The American Century fund recently sold at $80 per share and will pay $100 at maturity.

Or you can buy regular treasury bonds or certificates of deposit. They’ll pay interest until maturity and redeem their face value.

You invest $70,000 to $80,000 of a $100,000 portfolio in your choice of these investments. The exact amount depends on interest rates when you invest. You set the investment in safe investments to ensure in 10 years you’ll have at least your $100,000 principal and a minimum return. Recently, if you bought a safe investment yielding 3.25% annually, you’d put about $72,600 in it.

Invest the rest of the money in a stock index fund or ETF, or any growth-oriented investment you like. If you have enough capital, you can invest this money in a diversified portfolio such as our hedge fund mutual fund portfolio. The insurers will be more aggressive. Instead of investing directly in stocks they’ll purchase futures or options on the stock indexes. This gives them some leverage and could allow them to invest more in the safe investments.

Even if your stock investments lose money, you’re guaranteed your principal plus a minimum return after 10 years. If the stocks or whatever other vehicle you choose earn positive returns, your return increases. Unlike with an EIA, there’s no cap on your returns. Should your risky investments soar, you’ll reap the full return.

There are two more benefits to building your own EIA. One is when you need money the entire portfolio can be sold at market value. You aren’t subject to the annual 10% withdrawal limit or substantial surrender fees of EIAs. The other benefit is your gains from the stocks are likely to be long-term capital gains. You won’t pay the ordinary income taxes imposed on distributions from an EIA.