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How to Build Your Own Equity-Indexed Annuity

Last update on: Jun 22 2020

Equity-indexed annuities and other “structured products” have been hot sellers the last few years. Unfortunately, few people who buy or sell them really understand these investments. The investors are surprised that the returns are not as high as expected.

The basic pitch of structured investments is a guaranteed return of at least the initial investment after a period of years (usually ten) and perhaps minimum guaranteed interest of 1% to 3%. In addition, the investor has the potential to earn returns tied to the stock market.

We have discussed equity-indexed annuities in the past, and those discussions are in the Archive of the members’ section of the web site. Products similar to EIAs are available from banks and brokers and are sold under a number of names. Their generic names include structured notes, principal-protected notes, and indexed certificates of deposit. Each bank and broker uses more attractive names, such as Bank of America’s Minimum Return Eagles.

The products issued by insurers and brokers are unsecured obligations of those firms. Those issued by banks might be backed by the Federal Deposit Insurance Corporation up to its insurance limit. Investors should remember this distinction when they hear that the investments are guaranteed.

A trick to structured products is that the investor will not receive the return of a major stock index if the indexes do well. The products usually have “index” in their names and refer to a major index when explaining how gains will be credited to the accounts. But as we have discussed in the past regarding EIAs, an account will not be credited with the full gain of the index.

Most of the products have a ceiling on the gains that will be credited each year, usually around 7%, regardless of how well the index does. In addition, formulas are used to determine the return on the account. An investor does not earn the total return of the market index for the year. Instead, the formula might take the average value of the index for the year. Or it might add the quarterly returns of the index. In addition, the formulas usually do not include dividend income.

There are several basic formulas used in EIAs, and they have variations. The point is that the investor will not earn the index’s return and probably will earn far less than the index’s return in a good year, before considering the annual ceiling. When evaluating a structured product, be sure to determine the amount that would have been credited in the last few years so you understand the limits.

Structured products also have high expenses and pay brokers high commissions. To pay for the commissions, most of the products impose high surrender charges on investors who want a distribution before the guarantee period, usually seven to 10 years.

The attraction of structured products is that the investor has the potential to earn more than a bond or certificate of deposit while being assured that the worst case is a return of the principal after about 10 years.

What many investors do not realize is that they are able to get similar results themselves without the high fees or restrictions of the structured products.

One way to get a similar result is to invest in a quality balanced fund. Most good balanced funds that invest with value strategies and a margin of safety have few years with negative returns. Dodge & Cox Balanced (closed to new investors) had only one negative year in the last 10. The same goes for Vanguard Wellesley Income, Vanguard Wellington, FPA Crescent, and Oakmark Equity & Income (available only by direct purchase through Oakmark). You also can consider Hussman Strategic Growth, which hedges against market declines.

Another strategy is to attempt to replicate what the firms that sell structured products would do with your money.

You can purchase zero coupon bonds that will guarantee the return of your principal in 10 years or so, or purchase the American Century Target Maturity Series 2015 fund. Suppose you have $100,000 to invest. If you put between $70,000 and $80,000 in zeros today, you will receive about $100,000 in 10 years. You can invest the rest of the investment capital in a stock index fund or any mutual fund you like. With this strategy, if the stock market does well you benefit from the full return of the index. If stocks do poorly, your initial investment still is returned.

The structured product firms are a little more aggressive. Instead of purchasing an index fund, they use derivative products. They generally purchase call options on the stock index. If you expect stocks to do well or simply want to bet on a high return from stocks, you can purchase options that return a multiple of stock gains if the index does well. You also can purchase a leveraged index fund, such as those available from ProFunds and Rydex.

Structured products are very appealing. But investors can achieve similar benefits without the costs and restrictions by focusing on that old-fashioned investment principle of diversification.



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