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How To Create Your Own Indexed Annuity

Indexed annuities are a life insurance company product sold by insurance brokers for a commission that is based on the amount deposited into the contract. Contract performance is linked to popular indexes like S&P 500, and early withdrawal penalties typically apply for the first 7-10 years if withdrawals greater than 10% of the contract value are taken each year.

Many conservative investors buy these products to have downside protection in years when the index declines in exchange for limited upside potential in years when the index rises. In this article I’ll illustrate an example of how conservative investors who might be attracted to indexed annuities could replicate the risk/reward characteristics of index annuities using simple low-cost index mutual funds. I’ll then compare the historical performance of both strategies based on an illustration I recently received for an indexed annuity product that is popular among brokers.


Indexed Annuity Hypothetical Performance, 1993-2020

The below screenshot is from one of the top providers of indexed annuities in the US. Many indexed annuities are extremely complex and very difficult for consumers to understand, but this one is straightforward and does not include any other features such as an income rider that are often added on to the contract for an additional fee. The insurance company provides a floor of 0% in years where the index is negative, and a current cap of 4.4% in years where the index increases by more than 4.4%. In years where the index returns between 0% - 4.4%, the interest credited to the contract would be equal to the index return. This straightforward floor and cap methodology makes it very simple to illustrate what the growth of $100,000 would have been over the last 28 years.



$100,000 would have grown to $231,479, an average return of 3.06% and a compounded return of 3.04%. This is less than one third of the average return of the index. A popular way to replicate actual index performance is to own an index fund such as the Vanguard S&P 500 index fund, which would have grown $100,000 into $1,460,176. Many people who are anti-index annuity will point out this massive performance difference, which is unquestionably true, but it ignores the reason why most people purchase these annuity contracts which is downside protection. Therefore, a conservative portfolio of index funds with similar risk/reward characteristics is a more appropriate comparison.


Conservative Index Fund Portfolio vs. Indexed Annuity, 1993-2020

Life insurance companies typically take contract deposits received by purchasers and buy derivative contracts such as index call options paired with fixed income securities to create the floor and cap combinations that support the underlying guarantees in the contract. While this same process could be implemented by individual investors, it’s too complex for most people. A simpler approach is to pair an equity index fund, such as the Vanguard 500 fund, with short and intermediate term high quality bond funds. In the following example, the exact portfolio utilized is displayed below and a direct link to performance data can be found HERE. Rebalancing is assumed to occur based on 5%/25% rebalancing bands. A total of only 12 rebalancing trades would have been necessary over the last 28 years.




The conservative portfolio of index funds is the clear winner, at least over the last 28 years. I highlighted negative years in red, and although the index annuity has a 0% floor, that floor has been of little value when compared to a conservative index fund portfolio with only 15% equity exposure. This was true even in 2008 when the index lost 38.49%. The ending wealth is more than twice as much with the index fund portfolio, and the investor would also maintain full liquidity. In a non-qualified account, the index annuity would have the advantage of tax deferred growth (a US tax law feature of all annuities), but with the tradeoff of all withdrawals of earnings being taxed as ordinary income. After tax returns would be the same in a qualified account such as a Traditional or Roth IRA.



The downside protection features of many life insurance company products often appeal to the emotions of an average investor, and commission-based brokers will often play on these fears when marketing annuity products. The truth is that insurance companies don’t have a magic wand, and in most situations a better risk/reward profile can be created with low-cost index fund portfolios containing low equity exposure. An exception would be lifetime income immediate annuities, which are a separate product from what is discussed in this article, as they add an additional component to returns known as mortality credits that cannot be easily replicated. For this reason, academic research is typically in favor of immediate annuities for retirement income planning while conclusions are much more mixed on the benefits of indexed annuities. The next time you receive a postcard from your local annuity salesman offering a free steak dinner if you listen to a pitch about the latest and greatest indexed annuity, keep this article in mind and know the hard sell is likely to follow. If you currently have an indexed annuity and would like to receive a second opinion, please feel free to reach out to me at


Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University.


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