Equity-Indexed Annuities are popular but complicated.

Sales of these products have sky-rocketed in the past few years, since they have been touted as being the panacea for investors, usually seniors, who want to have guarantees, but want upside investment potential. These are complicated products that potential purchasers should understand before buying. But first, let’s review the bidding about annuities in general.

An annuity is a contract between the owner (annuitant) and an insurance company, in which the company promises to make periodic payments to you either currently or in the future. Payments that will commence at a later date are known as deferred annuities, and those that begin now are immediate annuities. Deferred annuities have two distinct phases--an accumulation phase during which the invested premiums earn interest, and a payout phase.

The method of determining the payments during the payout phase are usually based on the age of the annuitant or other factors.

You can purchase an annuity with a single payment or by a series of payments. Annuities are usually of two types: fixed or variable. With a fixed annuity, the insurance company will provide some type of guaranteed interest rate during the accumulation phase, but may also provide a higher current interest credit. Once a fixed annuity is in the payout phase, the payments are guaranteed. Fixed annuities have been popular over the past 15-20 years, since the interest credits have been better than CD interest rates, and also because of the income tax deferral that all annuities provide during the accumulation phase. The income taxation during the payout phase is favorable as well.

A variable annuity’s rate of return during the accumulation phase varies based on the type of investment accounts that you select:  bond-based, stock-based, or a money market fund. These products are regulated as securities by the SEC and, as such, must comply with a host of requirements and disclosures that are designed to protect investors.

Equity-indexed annuities (EIA’s) are hybrid products, since they may offer a minimum guaranteed interest rate in concert with an interest credit that is linked to a stock market index, such as the S & P 500. They have less market risk than a variable annuity, but they also have the potential to generate better returns that a fixed annuity when the stock market is on the rise.

EIA’s are regulated in like manner to a fixed annuity, but pundits believe that eventually the SEC will have jurisdiction over their sales, and this will be good news for investors. At the moment, however, many of these products are being sold to older investors who could be taken advantage of by overly aggressive salespersons who sometimes gloss over key points.

EIA’s are complicated products with features that can affect the interest that can be earned. An investor should fully understand how a proposed product will compute its index-linked interest rate prior to purchase. Here are some of the features of EIA’s:

• The participation rate means how much of the increase in the stock
  index will “count” to determine your credited interest rate. If the
  participation rate is 90% and the index goes up 10%, your return would be 9% .
• Interest rate caps set a maximum rate of interest that can be earned during a period.
• Spread or margin means that a specified amount of gain from the
  index increase will be subtracted to determine your actual interest credit. A spread of 5% means that if the index goes up by 6%, your product would earn 1% during the applicable period
• The indexing method itself can dramatically impact the return that
  an investor would receive, and these methods are complicated as well.
• Many EIA’s provide a guarantee of principal, while a smaller
  number will guarantee a minimum interest credit.
• All of these products have surrender penalties during the first 5-10
  years, so you should be willing to keep your investment intact for at least the duration of the penalty period. 

The bottom line is that investors should not purchase an equity-indexed annuity without understanding how they work. Remember, these are long-term investments, and getting out too early may mean losing money.

Got a financial planning question for Greg? You may e-mail him at
greg@lifesolutionsonline.net.

Full disclosure: Greg Roberts is a certified life underwriter and a Certified Financial Planner. He holds an MBA from the Wharton School of Business. He is also the brother of Athens Patch editor Rebecca McCarthy.