Some index annuity bashers have suggested that people can do the same thing an index annuity does by putting most of their money in a long-term certificate of deposit and the rest in an index fund. The reasoning is because you’re getting all of the upside participation in the index — plus reinvested dividends — this gives you a better return than buying an index annuity with caps. OK, let’s see how that combo idea is working for you.

When this article was written, the average five-year CD rate was 1.63 percent. That means you’d need to put \$9,223 in the CD to guarantee \$10,000 in five years, leaving \$777 to invest in the index fund. If the index fund doubled in value in the next five years, you’d have \$1,554.

Adding the index fund value of \$1,554 to the \$10,000 value from the matured CD gives us \$11,554 — or the equivalent of an 11.6 percent participation rate on our original \$10,000. Using the CD/fund combo idea in a period where the index fund doubles nets an 11.6 percent total return on original principal.

Comparing returns
Now let’s see how you would have fared with this CD-index fund combo in recent times versus actual index annuity returns: The rates on five-year CDs at the start of three consecutive Octobers were 3 percent in 2003, 3.4 percent in 2004 and 3.8 percent in 2005. These low rates mean there wasn’t a lot of money left over to put in the index fund after buying the CD.

For these periods, the CD/fund combo grew by the end of the five years as follows: 2003-2008, \$11,711; 2004-2009, \$11,497; and 2005-2010, \$11,772. By contrast, annuity values, based on actual average index annuity performance data, ranged from \$12,102 to \$13,414. These examples ignore any taxes owed on the CD interest or fund dividends.

Fly in the soup
The fatal flaw in the logic of using a CD/fund combo as an index annuity alternative is the same factors that can make the combo more attractive also make the index annuity more competitive.

If rates are higher, less money is needed in the CD to protect the principal, so more money goes into the index fund. However, higher interest rates would also mean that index annuity participation rates and caps can go up. In addition, while a strong bull market helps the index fund it can also cause the index annuity to perform well.

The reality is index annuities have performed competitively in times of both high interest and low interest and rising and falling stock markets. They aren’t perfect, but they have been tested in the crucible of fiery financial markets and proved their mettle.