Can I build my own annuity?
August 20, 2014 by Kevin Startt
My son drove for a major pizza chain back in the day when they advertised that they could guarantee a 30-minute delivery. It was a great advertising promotion, until a couple of zealous delivery boys wrapped themselves in pepperoni around an old oak tree in front of a customer’s house. This promo begged the premise that only in America can a pizza get to your house faster than an ambulance.
So, if I can get a pepperoni and pickle pizza to the customer in 30 minutes or less, can I build a fixed indexed annuity (FIA) in 30 minutes or less using a zero coupon bond, low-cost index fund and some free duct tape while still providing the hybrid benefits of long-term care, lifetime income, a potential guarantee and throwing in some market like returns? Theoretically, we can build our own FIA super supreme from scratch, but the potential for wrapping our clients around the proverbial “oak tree” mentioned above is significant. Let’s see how we do it.
I go out and buy a 10-year zero coupon bond backed by an investment grade corporation to mimic a life insurance company credit with average duration to mimic the corporate bond and the maturity date on my indexed annuity. The yield to maturity on the average AAA-rated zero coupon bond, as of July 30, is 3.25 percent. A zero coupon bond works similarly to a savings bond or Treasury bill and does not pay any current income. The investor buys the bond at a deep discount, depending on the maturity, and when the bond matures at par, the interest is built in for the investor. I could have chosen a secondary market certificate of deposit (CD) from a major bank as well, because the zero coupon bond is subject to substantial interest rate risk unlike the CD.
So far the comparison looks good except for the fact that I have to pay 2 percent to my broker for buying the bond and 2 percent for selling the bond. The commission might even be higher in the somewhat unregulated tax-free bond market. So, I will pay less than I would pay the insurance company on a fixed indexed annuity.
I hear the nabob naysayers of FIA fiefdoms saying, “The customer does not pay an up-front sales charge on an indexed annuity!” That is similar to the broker trying to explain the difference between bid and asked prices on a bond sale. There is no free lunch. The wise customer knows someone is getting paid and it affects his net return in both cases. The problem with the do-it-yourself FIA using a zero coupon bond is that the insurance company absorbs the interest rate risk in the real FIA, whereas the customer gets clobbered when rates go up on the zero.
According to the world’s largest bond fund manager, PIMCO, if rates go up one percent, the 10-year zero coupon bond would drop 15 percent because no income is currently being paid out, as is the case with a traditional coupon bearing bond. So much for the pepperoni and free bread sticks. A do-it-yourself-er would see their principal melt like hot mozzarella on a Georgia dog-day afternoon if we had a substantial rise in interest rates.Now let’s talk about the special sauce: the potential to gain some return from the indices. If I buy an FIA, most of the time my returns are capped, or if they are uncapped, I am paying a “spread” or call it a fee to gain additional return. If I go buy a Schwab or Vanguard ETF Index fund, I may only pay .05 percent in fees, but I now have complete upside and downside on my fund. At a retiree’s age, why do I want to take the risk of a Japanese-style bear market from 1989 to the present, when from peak to trough my negative return was 86 percent? The U.S. market produced similar negative returns in the early years of the Great Depression. One Henry Blodgett-run tech fund even dropped 97 percent in the early 2000s, according to Morningstar.
I could possibly gain the same return of 86 percent as the NASDAQ did in 2000, according to Wikipedia. It would take an average retiree 25 years to recoup a negative year like the above at normal market return of 7 percent, if Bullish Bob just happened to retire in the year of dastardly delightful returns. We are in the fourth longest bull market now, according to Invesco, and still have not had a 10 percent correction. The longer we go without a correction, the uglier it may be when it happens.
So does it make sense to save a few bucks and create your own indexed annuity in 30 minutes or less? Insurance companies deploy a time-tested tool that provides the potential to unequivocally say: absolutely not! It is called dynamic hedging and provides the means by which options are bought to protect principal and provide some market return. As a broker in the early 1980s, I would get asked if I could write a covered call and buy a put on a stock. I would reply and still say, “We have a specialist who handles our options trading.” In other words, I don’t deliver “supreme with the works” pizza in 30 minutes or less if I don’t have the expertise.
Your options as an investor are to try to get the pizza or returns delivered in a big way in 30 minutes or 30 years, or turn the benefits of lifetime income, conservation of principal, assisted living benefits and growth of principal over to a professional with potentially 100 plus years of experience — like an insurance company that has seen depressions and recessions come and go and still made money for policyholders. The road to success is dotted with many tempting parking places. Building your own FIA is not one of them, I’m afraid.
