If you want to start a fight in a room full of financial planners, just bring up annuities. About half the room will argue that these are valuable products that offer guarantees to worried clients, the rest will contend that the guarantees are worthless and the fees are outrageous. But the truth is advisors don’t need to turn to annuity products to allay clients’ fears about market losses.

Put simply, annuities are a contract between an insurance company and an individual. They come in many shapes and sizes, ranging from very simple — such as a single-premium immediate annuity (often called a SPIA) that promises income for life in the form of a monthly guaranteed check — to mind-numbingly complex, like the fixed indexed annuity that promises equity-linked returns without risk of principal.

All, however, are indirect investments made through insurance companies and insurance agents, which profit as intermediaries. And those profits reduce returns for our clients. So to the extent that advisors can help clients achieve annuitylike results while cutting out the intermediaries, the clients are likely to have more money for life.

Here are some methods that will let you build your own annuity to increase your clients’ returns:


This annuity promises wealth without risk. It is usually marketed by promising part or all of the “market return,” with a guarantee not to lose principal. But since regulators require the insurance company’s assets to be invested conservatively, common sense dictates that the insurance company can only return a conservative (fairly bondlike) return — less the commissions, overhead and profits the insurance company needs to cover.

Typically, returns are linked to indexes like the S&P 500 stripped of dividends, and have maximum returns — which the insurance company often retains the unilateral right to change. I just reviewed one policy that had lowered the maximum return on an existing policy to 3.5% — meaning my client would get between 0% and 3.5% annually, but had to pay 10% of his principal if he wanted his money back.

It’s a feel-good product — but it’s also a product that you can easily mimic, with dirt-low costs and guarantees backed by the U.S. government. All that your client needs is a high-paying long-term CD and a low-cost stock index fund.

As of mid-April, GE Capital Bank had an FDIC-insured 10-year CD yielding 3.3%. If the clients have $100,000, for instance, they could put $72,276.45 in this CD, which would mature in 10 years at $100,000 — that’s the guaranteed principal.

Then your clients can put the other $27,723.55 into a low-cost total stock index fund such as Vanguard Total Stock ETF (VTI), which has a 0.05% annual expense ratio. In 10 years, the client gets back the $100,000 in the CD plus the value of the stocks, which will also include the dividend reinvestment.

Clients can do even better if they are willing to take on a minimal amount of risk. Let’s face it: If the value of stocks 10 years later were zero, then the U.S. government would probably have failed, as well. So we can do better if we assume rather conservatively that the total return of stocks (including dividends) would fall no more than 50% in 10 years.

In that case, the clients put $56,588.19 in the CD and the other $43,411.81 in the stock index fund. If it’s a horrible decade for stocks, in which the S&P 500 loses 60% of its value, the total stock fund with dividends reinvested would lose about half its value, and the client CD plus that stock (at half the original value) would be worth $100,000.

But here’s the upside: If stocks return 8% annually over the next decade, the guaranteed combination will earn 4.8% annually, while the “virtual guarantee” combination (which assumes stocks lose no more than 50%) earns 5.57% annually.

The How DIY Fares chart above breaks down the approximate returns based on how stocks actually perform. The do-it-yourself options are actually far superior to an equity-indexed annuity.

They can also be more tax-efficient. If the client buys the CD within a tax-deferred account, such as an IRA, but leaves the stocks within a taxable account, the stock dividends will be taxed at a lower rate and the capital gains will be deferred until sold — when they are also taxed at a lower capital gains rate.


Clients seeking longevity insurance often turn to annuities to get a guaranteed monthly check — either via a single-premium immediate annuity or with a deferred life annuity (sometimes called a deferred immediate annuity), which defers the start of those monthly payments to some specified date in the future.

There are costs and risks to both. While they are sold as income for life, most of the monthly payment is actually return of principal; there is no value after death.

You can get these annuities with payment escalators (such as a 3% annual increase), but buying a SPIA is essentially buying a bond with a duration that extends over the rest of the client’s life.
The biggest risk with these products is inflation, which is hard to predict: Double-digit price increases would make that “guaranteed income” actually guarantee a rapidly declining standard of living.

By far the best way for clients to build their own SPIA is to delay taking Social Security payments.
I recently compared delaying Social Security for four years against buying an annuity whose payment to the client began at just under $1,000 a month, beginning in four years. The annuity paid a 3% annual increase and would continue as long as either spouse was alive — similar to Social Security with a survivor benefit.

I shopped around and the lowest-priced annuity cost $235,500. But if the husband delayed his Social Security for four years, the couple would give up only about $126,000 in Social Security payments over the next four years and then get an inflation-adjusted additional Social Security check of about $1,000 — the same as the annuity’s monthly payment.

So, for about 46% less than the cost of an insurance company-backed annuity that might not keep up with inflation, the client bought a U.S. government-backed annuity with a payment escalator tied to the CPI.

If your clients want a bigger payment than what they can get by delaying Social Security — or if the client is past 70 — a 2012 paper in the Financial Analysts Journal offers an innovative solution. According to the authors — Stephen Sexauer, Michael Peskin and Daniel Cassidy — one could build a 20-year TIPS ladder combined with a deferred life annuity that starts in 20 years. 

Roughly 88% of the principal will go to TIPS ladder, and the deferred life annuity cost will be so low that it’s only about 12% of the total investment. (The cost of the annuity is essentially discounted because the insurance company prices in longevity data — including the fact it may not have to pay a dime if the annuitants don’t survive the 20 years.)

While this alternative does include buying an annuity, the insurance annuity portion is relatively minor, with most of the principal going to a direct investment.

It’s worth noting that although the clients have no inflation risk for the first 20 years, they do face risk beyond 20 years if inflation is more than anticipated. Still, this solution has far less inflation risk than spending the entire amount to buy the annuity, since inflation-adjusted annuity products are not on the market at this time. They may be soon — but at that point, inflation risk will certainly be priced into the payment, meaning such a product would probably pay far less than any currently available fixed-payment annuity.


Variable annuities are often marketed as offering mutual fundlike returns with a guarantee of future income, no matter what happens to the market. The subfunds the client can invest in are similar to mutual funds, but generally have even higher fees than the average mutual fund. And there are other costs as well: annual mortality and expense costs, as well as additional fees paid for riders that support the guaranteed income. I recently evaluated a typical one for a client, who turned out to be paying 3.35% annually in expenses for an “income guarantee” that was virtually worthless. In reality, the guarantee was a deferred income annuity that would start paying out in 10 years at a 2.5% annualized internal rate of return.

If inflation averages 3% annually, as it has historically, this annuity will give a real negative return. Meanwhile, my client would have paid 33.5% on his assets over the 20 years — and more if the subfunds increased in value.

The solution here was to avoid the expensive and virtually worthless guarantee altogether. A low-cost conservative portfolio has a much better chance of increasing in value — and later, when the cash stream is needed, the client can convert the portfolio to a cash stream as noted above in the income annuity solution.

You could, of course, construct a host of different portfolios, but a relatively conservative one that includes about 40% stocks could be as follows:

  • 40% iShares Aggregate Bond (AGG), 0.08% expense ratio;
  • 20% iShares Treasury Inflation Protected Bond (TIP), 0.2% expense ratio;
  • 27% Vanguard Total Stock Index (VTI), 0.05% expense ratio;
  • 13% Vanguard Total International Index (VXUS), 0.14% expense ratio.

At the end of the 10-year period, the client is likely to have far more money — and can then use one of the solutions discussed previously to build a larger annual cash flow stream.
In annuities as in investing, fees and returns are inversely related. And so the secret to all of these is reverse engineering: Figure out what the client wants to accomplish with the annuity product, and then develop a way to achieve the desired results without giving an insurance company a slice of the returns.

None of the above strategies perfectly mimics the annuity product, but all give clients a superior risk-adjusted return. The additional return comes from making direct investments and cutting out intermediaries, thus avoiding high commissions and fees associated with annuity products. FP

Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.

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