In a perfect world, there would be no downside. We'd never lose in Vegas, we could eat fattening foods without increasing our cholesterol or bulking up our waistline and we could get juicy stock market returns year after year without any risk.

Unfortunately the world is not perfect. But some believe it is possible to find equity returns without risk using a complex hybrid insurance product called equity-indexed annuities (EIAs), also known as fixed-indexed annuities.

This product does deliver some of the stock market's return, but there's a catch: Clients must pay hefty commissions ranging from 5% to 8%. It also locks up your funds for years unless you're willing to pay double-digit surrender fees if you change your mind.





























As an alternative, why not build an equity-indexed annuity-like portfolio for your client yourself? In addition to sporting lower fees, it will offer the key advantage of helping your client control irrational financial behavior by bringing peace of mind.



The basic idea is to combine two ultralow-cost products. First, buy the highest-paying long-term CD, investing just enough to ensure that the CD will grow to equal the entire pot of money you want to invest. Think of this as buying a zero-coupon bond. Then invest the remainder in a low-cost stock index fund or ETF. Your clients are guaranteed to get back at least their investment. To illustrate how this strategy plays out, consider this scenario investing $100,000 of client funds.

Interest rates on CDs are currently near a post-depression low. As of late February, the highest paying 10-year CD open to the public was Apple Federal Credit Union's 10-year CD with a 3.25% annual percentage yield (APY). This CD is backed by the U.S. government via the NCUA (National Credit Union Administration). Applying the strategy means the client needs $72,629 of the $100,000 to go into this CD to grow to $100,000 in 10 years.

The remaining $27,371 can go into Vanguard Total Stock Market ETF (VTI), with a 0.07% expense ratio, or into the Vanguard Total International Index Fund ETF (VXUS), with a 0.2% expense ratio. Combining the two ETFs provides some global equity exposure.



What the client gets back depends on how the stock market performs over the 10-year period. In the worst-case scenario, the value of the stock market goes to zero over 10 years and the client only gets back his or her $100,000 (see "Surviving the Worst Case," on page 94). The government would also likely be out of business, and I suspect we would all have much more to worry about than our portfolios.

Or imagine less of a doomsday scenario, where the stock market loses 6.7% annually, equating to a 50% loss over 10 years. The client nets a 1.3% annual return on the full $100,000. If returns are the same as in the first Lost Decade of this millennium when stocks returned 0%, the client would actually make 2.4% annually. But if the stock market earns 8% annually, the client captures 60% of the stock market gain, with a 4.8% return.

You might remind clients that the Lost Decade of 2000-2009 included the collapse of both the technology and real estate bubbles and still broke even. Now you can put $57,019 in the CD and $42,981 in the equity ETFs and, under the worst-case scenario, get back your original $100,000 investment.

If stocks earn a more reasonable 8% on average annually, the client will net 5.5% a year rather than the 4.8% in the original example. The client gets 69% of the stock market return, on an annualized basis.

Earning a 5.5% return generates $70,814 in gains, while an 8% return garners $115,893 in gains. It's important to remember that compounding a lower return results in only receiving 61% of the stock market return over the full 10 years.



Insurance companies often sell annuities with bonuses, and this annuity has them as well. In fact, the do-it-yourself annuity offers several bonuses over EIA products that are currently on the market.

* Lower income tax. Ordinary annuities are taxed as ordinary income. In the build-it-yourself annuity, the dividends from the stock index fund are taxed at a lower rate (at least for now) and capital gains, which will be taxed at a lower rate, are deferred. You can further minimize taxes by opening the CD in the client's IRA account and putting the stock index fund in a taxable account. This way clients keep more of the gain.

* Uncle Sam's guarantee. Insurance annuities are not backed by the U.S. government. Sure, there are some state protections in place, but the states usually rely on getting their funding for that protection from other insurance companies.

How strong would that protection be if we had a systemic failure like we did in 2008, but without a government financed bailout? Currently bank accounts are federally insured for up to $250,000 under the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in July 2010.

* Lower withdrawal penalties. Equity-indexed annuities usually come with stiff early-withdrawal penalties over periods as long as 15 years. Our Apple CD happens to have a pretty nasty early withdrawal penalty of up to three year's interest. But many CDs have penalties as low as two months' interest. Because some banks and credit unions don't allow partial withdrawals, it is prudent for clients to open several smaller CDs in case they need some of the funds at some point during the 10 years.

* Free death rider. Should the client pass away at anytime during the 10-year period, Uncle Sam will give the estate a free death benefit in the form of the step-up tax basis on the stock ETF. This step-up in tax basis eliminates any taxes paid on the gain.
















Despite all of these practical advantages, the biggest benefit of the do-it-yourself annuity is peace of mind. I will never forget my clients' distress in late 2008 and early 2009 as they watched their incredible shrinking portfolios. Few investors, even those working with financial advisors, had as much tolerance for risk as they thought they had in 2007, and many ended up reducing their equity exposure just before the markets recovered.

The annuity-like strategy will help to keep clients on a straight course. During the dark days of the plunge, many of my clients were comforted knowing that much of their equity losses would be returned in the form of gains from the maturity value of their CDs.

We know that there will be more plunges to come over the next few decades, and the news media will amplify the fear when these plunges happen. If your clients understand that they will, at least, get all of their money back, they are far more likely to stay the course during the next stock market plunge. With the U.S. stock market within 5% of an all-time high (total return of the Wilshire 5000), now is the perfect time to build this annuity-like protection for your clients.

It's true that inflation may eat up a good part of the return. But clients usually think in nominal dollars, and the idea of getting back their $100,000 could prevent a panic sale at just the wrong time. I'm guessing we all had a client or two (or more) who did just that during the last market downturn.

This strategy is viable even with today's historically low CD interest rates, but Treasury interest rates are starting to move up and CD rates are likely to follow. According to founder Ken Tumin, CD rates typically lag Treasuries by about one to two years.

If long-term CD rates move back to 6%, where they were only four years ago, then only 56% of the funds would be required for the CD, leaving a 44% allocation to equity funds to provide much more of the market upside (see "Looking Up," at left). Should CD rates climb to 10% (we've seen it before), less than 39% of the portfolio would need to go to the CD.

As Warren Buffett once stated, "Investors should remember that excitement and expenses are their enemies." This build-your-own annuity strategy starts with the low costs of index funds and directly purchased CDs. It then combines the low costs with an emotional guarantee to clients that they will get all of their money back at the end of a defined period, helping them to stay the course in bad times.

A do-it-yourself annuity isn't the elusive magic bullet for earning stock market returns without risk. It is, however, a low-cost way to build a balanced portfolio with a mental guarantee for client that they can't lose principal-no matter what market conditions may turn out to be waiting for them in the future.


Allan S. Roth is the founder of Wealth Logic in Colorado Springs, Colo. He writes the "Irrational Investor" for CBS MoneyWatch and is also an adjunct faculty member at Colorado College and the University of Denver.

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