Many conservative investors buy these products to hedge against price losses in years when the index is falling, in return for limited upside potential in years when index values ​​are rising. In this article, I’ll illustrate an example of how conservative investors who might be drawn to indexed annuities can replicate the risk-reward characteristics of index annuities with simple, low-cost index mutual funds. I then compare the historical performance of both strategies using an illustration I recently received for an indexed bond product popular with brokers.

Hypothetical Performance of Indexed Pension Insurance, 1993-2020

The screenshot below is from one of the leading providers of indexed annuities in the United States. Many indexed annuities are extremely complex and very difficult for consumers to understand, but it is straightforward and does not include other features such as an income tax, which is often added to the contract for an additional fee. The insurance company provides a lower limit of 0% in years with a negative index and a current upper limit of 4.4% in years in which the index rises by more than 4.4%. In years in which the index return is between 0% – 4.4%, the interest credited to the contract corresponds to the index return. This simple floor and cap method makes it very easy to illustrate what the $ 100,000 growth would have been like over the past 28 years.


$ 100,000 would have grown to $ 231,479, an average return of 3.06% and a cumulative return of 3.04%. This is less than a third of the index’s average return. One popular way to track actual index performance is to own an index fund like the Vanguard S&P 500 index fund, which would have grown $ 100,000 to $ 1,460,176. Many people who are anti-index annuities will point out this massive difference in performance, which is undoubtedly true, but it ignores the reason most people buy these annuities, which is a hedge against loss. 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 from buyers and purchase derivative contracts such as index call options paired with fixed income securities to form the combinations of floor and ceiling that support the underlying guarantees in the contract. While the same process could be implemented by individual investors, it is too complex for most people. A simpler approach is to combine a stock index fund like the Vanguard 500 fund with high quality short and medium term bond funds. In the following example, the exact portfolio used is shown below and a direct link to the performance data can be found HERE. It is assumed that a rebalancing will be carried out on the basis of 5% / 25% rebalancing bands. In total, only 12 rebalancing trades would have been necessary in the last 28 years.



The conservative portfolio of index funds has been the clear winner for at least the last 28 years. I’ve highlighted negative years in red, and while index pension has a floor of 0%, that floor was of little value 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 final assets are more than twice as high in the index fund portfolio and the investor would also retain full liquidity. In the case of an unqualified account, the index pension would have the benefit of deferred tax growth (a feature of all US tax annuities), but all profit withdrawals would be taxed as ordinary income. Post-tax returns would be the same in a qualified account such as a traditional or Roth IRA.


The coverage features of many life insurance products often appeal to the emotions of the average investor, and commission-based brokers often play with those fears when marketing annuity products. The truth is that insurance companies have no magic wand and, in most situations, a better risk / return profile can be created with inexpensive index fund portfolios with low equity exposure. The exception to this is the Immediate Lifelong Income Annuities, which are a separate product from those discussed in this article as they add an additional component to the rate of return known as mortality credits that cannot be easily replicated. For this reason, academic research tends to favor immediate annuities for retirement income planning, while conclusions about the benefits of indexed annuities are much more mixed. The next time you get a postcard from your local annuity seller offering a free steak dinner when you hear a pitch about the latest and greatest indexed annuity insurance, keep this article in mind and know the hard selling is likely to follow becomes. If you currently have an indexed pension and would like a second opinion, please feel free to contact me at [email protected]

Jesse Blom is a licensed investment advisor and vice president of Lorintine Capital, LP. He advises clients in the USA and worldwide. Jesse has been in the financial services industry since 2008 and is a CERTIFIED FINANCIAL PLANNER ™ Professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse holds a BS in Finance from Oral Roberts University.


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