Primarily used as a stream of income for retirees, an annuity is a financial product that distributes fixed payments.  Annuities are offered by financial institutions.  The accumulation phase of an annuity begins once its first funded and ends with a payout.  Once distributions begin, the annuity moves to the annuitization phase.  Annuitization occurs when the annuity investment converts, so to speak, into a stream of income payments. 

Life insurance companies have been marketing the promise of lifetime income during retirement to Americans by way of annuities.  In the beginning, annuity contracts were a simple investment vehicle that paid a fixed interest rate, and subsequently paid a guaranteed stream of income that was impossible for the beneficiary to outlive.

 

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In the late 1980s, variable annuities made their debut with their commitment to higher returns from mutual fund subaccounts.  In an effort to establish fair market participation of the more conservative investors, indexed annuities were introduced the following decade.  Key benefits of all annuity contracts include:

  • Exemption from probate
  • Unlimited tax-deferral contributions
  • In most cases, protection from creditors
  • Protection from superannuation, or surviving past one’s income

Unfortunately, annuities are one of the most expensive investments on the market currently.  They usually include an exorbitant amount of fees and other costs, which can significantly reduce the cash value and principal within the annuity contract.  The high expense ratios of annuity contracts have caused concern for industry authorities and experts over the years, which has led to annuities still being the focal debate in the financial industry.

Do It Yourself – The Self-Directed Annuity

 

What is a self-directed annuity?  This is where the financially sophisticated consumer builds their own portfolio with individual securities basically reproducing the contracts offered by commercial carriers.

First, you need to understand exactly how most annuity service providers manage their investment portfolios.  Most life insurance companies invest their cash reserves in a conservative mix of stocks, bonds, and other financial products just so it grows at a rate that provides for the financial needs of the company while still making a profit.  The referenced cash reserves is an accumulation of funds sourced from clients, fees, and other charges to ensure and maintain the policies.

However, those who design their own annuity do not have to pay associated costs and fees or meet cash reserve requirements.  Those choosing the self-directed annuity will retain a substantially larger portion of their profits depending on their strategy.

Fixed Annuities

 

Reproducing the interest paid from a fixed annuity is relatively basic.  You can design an investment portfolio of fixed-income securities with a risk level that you are at peace with.

If you choose the conservative route, try utilizing certificates of deposit (CDs) or treasury securities.  Those who entertain a higher risk tolerance may choose from corporate bonds, preferred stock investments, or other comparable vehicles that provide a higher interest rate with price stability.

Your income from a fixed annuity will vary as interest rates fluctuate, but so do annuity payments.  Insurance companies cannot distribute more than their underlying bond portfolio produces.  After the initial period, state law mandates that they can fall to a minimum rate, typically 2-3% where they are sold.

Indexed Annuities

 

Designing an investment portfolio that replicates the returns provided by indexed annuities is more complicated than replicating a fixed policy payout.  Indexed annuities are financed by the combined guaranteed investments of treasury securities, index options, and guaranteed investment contracts.

For example, an insurance carrier might invest $85,000 in guaranteed investment vehicles out of every $100,000 of indexed annuity premium received, which will then grow to equal the original principal amount, or maybe a bit more, by the time the annuity matures.  The investor will then take another $10,000 to purchase call options on securities the annuity contract uses like the S&P 500 Index.  The remaining $5,000 would then be used to pay for contract expenses or other costs, such as the broker’s commission.

Most indexed annuity contracts grow in value if the index rises and have limitations on how much profit investors can receive.  Now, most contracts have caps over a specified time, such as 8% per year.  The carrier keeps any excess growth above the cap level should the index rise by more than that amount.

However, in a self-directed annuity, the investor can divide up their investment and purchase one or more fixed-income securities, which will increase back to the original principal amount by a predetermined date in the future.  Any form of guaranteed security can serve this purpose, but Zero-coupon bonds work great for this.  The remaining funds could then be used to purchase buy calls on the index of your choice, which generally should be a stock index.

You must possess a basic knowledge of how the options work in order to do it successfully.  Those lacking experience in this area would want to recruit the assistance of a stockbroker or financial advisor.  However, this strategy is simple and yields the same results as a commercial contract, minus the caps and other fees associated with these contracts.  Those seeking these types of self-directed annuities can count on moderate to affluent gains with little to no risk to the principal.

Strategy Limitations

 

Unfortunately, these portfolios will be unable to provide the insurance coverage found with commercial annuity contracts, for example, survivable guaranteed income distributions.  To receive this form of protection, the self-directed investor must annuitize the contract, which means surrendering control of the contract to the insurance company in exchange for a fixed payout for life.

For this very reason, most annuity owners choose alternate forms of payout, such as a required minimum distribution at age 70 ½ or systemic withdrawal.  Additionally, the only way this portfolio will grow tax-deferred is if it’s inside a traditional or Roth IRA.  Many IRA overseers don’t allow the use of options in their accounts.  You will want to find a self-directed IRA custodian to facilitate options trading.

Duplicating the interest payments provided by indexed and fixed annuities does have limitations.  However,  it can be more profitable by offering higher returns than their commercial counterparts.  Consult your experienced financial advisor regarding what is a self-directed annuity and how you can earn similar investment returns.

 

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Frequently Asked Questions

How does a self-directed annuity differ from a traditional annuity?

The primary difference lies in the investment control. In traditional annuities, the insurance company generally manages the funds, offering a set interest rate or a selection of investment options. With a self-directed annuity, the owner has the autonomy to select from a broader range of investment options, which could include stocks, bonds, real estate, and other assets, depending on the terms of the annuity contract.

What are the primary advantages of a self-directed annuity?

The main advantages include:

  • Greater control over investment decisions.
  • Potential for higher returns based on personal investment choices.
  • Diversification beyond the standard offerings of traditional annuities.
  • Tailored strategies to match individual risk tolerance and financial goals.
Are there risks associated with self-directed annuities?

Yes. With increased control comes increased responsibility. The risks include:

  • Potential for losses if investments don’t perform well.
  • Lack of professional management, which may lead to suboptimal investment decisions.
  • Possible higher fees and administrative costs depending on the brokerage or platform chosen.
Can anyone open a self-directed annuity?

While most people can open a self-directed annuity, they are especially suitable for those who have a good understanding of investment strategies and markets. It’s essential to consult with a financial advisor or specialist to determine if this type of annuity fits one’s retirement planning needs.

How can I get started with a self-directed annuity?

Begin by researching and identifying insurance companies or financial institutions that offer self-directed annuities. Once you have shortlisted a few options, consult with a financial advisor to discuss the terms, fees, and investment options available. Once you’re ready, you can set up an account, make your initial investment, and start directing your investments based on your preferences.

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