Consider building a portfolio of CDs and index funds to protect your principal and potentially boost returns.

Indexed annuities and other principal-protected products have experienced strong sales in recent years. Investor fear stemming from the financial crisis of 2007 and 2008, along with persistent low interest rates, might offer an explanation for this. Unfortunately, the return potential offered by these vehicles usually leaves a lot to be desired.

Complex features including caps, participation rates, surrender periods and returns linked to proprietary indices rarely benefit the investor. Additionally, these products typically do not benefit from dividends, which are the source of a large portion of stock market returns. The marketing material may tout high returns, but they often shows hypothetical back-tested performance from a time period with significantly higher interest rates than today, setting unrealistic expectations. Indexed annuities may also carry credit risk in the unlikely event that the company issuing the product does not have the financial capacity to meet its obligations.

Fortunately, if fear of the market crashing keeps you up at night, a portfolio featuring two simple components may provide greater safety and performance than the majority of indexed annuity products.

The first component of this approach, comprising the majority of investment dollars, is the purchase of one or more certificates of deposit. There are banks offering CDs insured by the Federal Deposit Insurance Corporation with rates of more than 2% for a 10-year term. You can also obtain rates over 2% utilizing brokered CDs available on most brokerage platforms.

The second component involves purchasing a low-cost index mutual fund, representing the global stock market. Utilizing this strategy, the investor can rest assured that the value of the CDs at maturity will be at least equal to the entire original investment.

Here’s an example: Robert has $100,000 that he would like to invest but he prefers to avoid taking too much market risk. He does not anticipate needing to access this investment for ten years. First, he could invest $81,000 in a 10-year CD with an interest rate of 2.2%. At the end of ten years, this $81,000 invested in the CD would be worth a bit more than $100,000.

At the same time, he could invest the remaining $19,000 in a low-cost global stock index fund, with dividend reinvestment, to help him benefit from the power of compounding. Regardless of the return of the index fund, his CD will be worth more than the initial $100,000 at maturity. If the index fund were to return an average 9% a year, the value of his original $100,000 investment would be worth approximately $145,000 after 10 years. Even in an unfavorable (and unlikely) scenario in which the stock market decreased 25% over the 10-year period, the CD combined with the index fund would still show a gain of approximately $14,000.

Impact of Early Withdrawal

One important consideration for utilizing CDs is the likelihood of needing to access the principal before maturity. CDs purchased from a bank that are accessed before maturity are usually subject to an early withdrawal penalty. As a basis of comparison, the surrender charges for early withdrawal from indexed annuities are typically much higher than these penalties. Brokered CDs pay out the face value at…