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Equity-Indexed Annuities Aren't Worth the Confusion

These insurance products limit stock market risks but are complex and difficult to compare.

Equity-indexed annuities let investors have it both ways: They track the stock market's gains, but with less downside risk than an index fund or an exchange-traded fund. That's an appealing concept, particularly when there's so much concern about the housing market. But these insurance products also have some serious drawbacks.

Annuities are contracts between you and an insurance company: You make a single payment or series of payments, called premiums, and the insurance company periodically makes payments back to you. With a fixed annuity, the insurer guarantees the rate of return; with a variable annuity, the rate of return varies with the performance of the investment option you choose -- you could earn a higher rate of return than a fixed annuity, but you could also lose money.

Equity-indexed annuities are a kind of hybrid. They offer more upside, but also more risk, than a fixed annuity, but they have less risk, and also less upside, than a variable annuity.

The problem is that it can be extremely difficult to understand how much of an index's return you are giving up in exchange for the guarantee that you won't lose money. The methods used to calculate your return can be complex and differ from one insurer to another, making it difficult to compare products. Even more confusing, the method for calculating returns can change from year to year

within the same policy

, depending on the performance of the stock market.

Some of the features used to limit both the downside and upside of returns on equity indexed annuities include:

  • Interest rate caps: This is the maximum rate you will earn, and it is usually the average of the index's performance over the year. (The way the average is calculated varies from one provider to another.) No matter how much the index actually returns, this average is all you get. In other words, if the contract has a 6% cap but the index average performance over the year is 10%, the amount credited to your investment will be 6%. Because interest rate caps can be reset each year depending on the performance of the market, there are also guaranteed caps.
  • Guaranteed caps: A guarantee cap will guarantee that the interest rate cap will not go below a given percentage. For instance, if a product has a guarantee cap of 5%, this means the interest rate cap cannot be reset below this amount. (But you can still earn less than 5% if the market's rate of return falls below that level.)
  • Participation rate: This is the percentage of an index's performance that will be credited to your account. If the participation rate is 80% and the index returns 9%, your account will be credited with 80% of 9%, or 7.2%. The participation rate may also be reset year over year and can vary from 45% to 100%.
  • Margin: Also known as a spread, this is the percentage of an index's return that will be subtracted before crediting your account. For instance, if the spread is 3% and the index returns 8%, the amount credited to your account will be 5%. Again, this amount can be reset year over year and can vary from zero to 100%.

Equity indexed annuities can also feature one-time premium "bonuses." This is a fixed percentage of the premium, usually for a single premium amount paid in the first year of the policy. Obviously, it's an incentive to get investors to put as much money up front as possible. Some insurers offer premium bonuses as high as 12%. So if you decide to invest $100,000 and transfer this amount as a one-time lump, the insurer will credit you $12,000, leaving you with $112,000.

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Some equity indexed annuities also feature floors, or guaranteed minimum returns, which average around 3%.

Contract features can change as often as

twice a year

, so it's important to understand the terms. Equity indexed annuities are designed to adjust their terms according to the performance of the market. Contracts with higher guaranteed minimums may perform better in a down market, while some products that either have no cap or a higher participation rate may perform better if the market does well.

Complex terms aren't the only drawbacks to equity-indexed annuities, however. According to Advantage Compendium, a research and consulting firm, half of the these products credited policy-holders with simple interest, not compound interest. Compounding, or adding interest to the principal, is one of the most powerful ways to grow your investment. If you only receive interest each year on the basis of your original principal, your cumulative returns will be much lower.

Equity indexed annuities also apply big fees to early withdrawals (those made before age 59 ½). These can be big enough to eat into your principal investment. Some insurers will charge as much as 20%, although the amount usually declines each year until maturity. When you make an early withdrawal, you also lose the initial bonus premium and in some cases the interest on your investment as well.

Investors who want to earn at least some of the stock market's returns might be better off constructing their own portfolio of Treasury bonds and mutual funds. Treasury bonds provide stability with a guaranteed rate of return while mutual funds can provide an opportunity for compound interest growth without all the commission and surrender charges

Remember, any insurance product is a contract between you and an insurance company. So it's important to make sure the insurer has a strong financial rating. The assets in equity-indexed annuities are held in insurers' general accounts. This means that if the insurance company fails, you could loose part or all of your investment. Ratings updates its ratings quarterly, and they are available

here free of charge.

Melanie Dufour joined TSC Ratings as a life and health insurance analyst in February 2007. She has an actuarial background with a BS degree in Actuarial Mathematics and Finance from Concordia University in Montreal, QC. Melanie has most recently worked as an actuarial analyst with Aequicap Insurance Company in Ft. Lauderdale, FL and prior to that as a senior analyst with Watson Wyatt Worldwide in Montreal, QC.