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5 Facts About Equity-Indexed Annuities

Jeff Brown

Equity-indexed annuities offer a minimum investment return along with the chance to share in stock-market gains. It sounds great but these insurance products, also called indexed annuities and even fixed indexed annuities, have been heavily criticized over the years for heavy fees, opaqueness, lack of liquidity and disappointing results.

They're still out there, though, and might appeal to investors wanting fixed-income safety with hopes of inflation-beating gains.

"An index annuity is absolutely appealing in this environment, because we are at an all-time high," says Ty J. Young, a financial advisor in Atlanta, citing stock prices, corporate revenues and stocks' price-earnings ratios. "Many folks are therefore looking for a place they can have their money protected and have it growing at the same time. An index annuity does that for them."

[See: 20 Awesome Dividend Stocks for Guaranteed Income.]

But debate over this product's pros and cons has not settled down.

These products offer tax-deferral on gains similar to what investors get in individual retirement accounts and 401(k)s, though there is no deduction on contributions.

A modest yield. Many index annuities guarantee a modest annual yield of 1 percent to 3 percent, plus gains linked to a stock market index like the Standard & Poor's 500 index. Investors hope that with limited or no risk to principal, they can earn more than in certificates of deposit, money market funds or bonds.

"There are many variations on how insurance companies create such contracts with their customers, but all of them support the limiting-downside-risk-by-muting-potential-upside-gains theme," says Ryan Johnson, head of partnerships at True Link Financial, a web-based investment advisory firm. "It's like bowling with bumpers in the alley. There is no glory but at least you won't throw a gutter ball."

The biggest dig is that these annuities often don't pay off as well as investors expect, especially investors accustomed to stocks. A Fidelity Investments report shows that from 2005 to 2015, the average annual return of the S&P 500 index was 7.31 percent (5.05 percent without dividends). The indexed annuity returned only 3.14 percent annually.

They offer a safety net. So who is the ideal candidate for an indexed annuity?

Financial advisor Bruce A. Sanders of Waddell & Reed in Alpharetta, Georgia, says indexed annuities can work for "those seeking protection in a falling market, who have a long-term investment goal, and who have maxed contributions to other retirement plans ... and need a tax-deferred investment vehicle."

Young investors with time to ride out stock dips are not as likely to benefit from indexed annuities as older folks willing to give up some investment gains in exchange for protection of principal, he says. While protection against loss comes at a high price, these annuities become more popular in times of market uncertainty, he adds, pointing to current factors like a new administration, rising interest rates, volatility in energy markets and international tensions.

They're hard to understand. One of the most common criticisms is that index annuities, like many complex insurance products, are hard for ordinary investors to understand. They can use unfamiliar terminology and have provisions that kick in only under certain circumstances.

[See: The 9 Best Municipal Bond Funds for Tax-Free Income.]

"Beyond understanding how the return is actually calculated, potential investors need to look at the annual fees the insurance or annuity company charges," says Coleen Pantalone, finance professor at the Northeastern University's D'Amore-McKim School of Business. "Investors also need to look at the surrender charges -- what happens if you want out of the investment? These are long-term investments and you are usually penalized by the annuity seller for pulling out early."

"Many have extremely long surrender charges," says critic Ed Snyder, a financial planner with Oaktree Financial Advisors in Carmel, Indiana. "I recently met with a couple who were sold one with a 16-year surrender charge that started at 17 percent."

He adds that, "Equity-index annuities are sold, not bought. If people really knew what they were getting they would not choose to purchase them."

Caps and participation rate. In many cases the investor receives less than 100 percent of the stock market gains. If the index rises by 10 percent and the annuity has a 3 percent cap, the investor would receive only 3 percent, according to Fidelity. There also may be a "participation rate" that credits the account with only a portion of the index's gains below the cap, such as 80 percent, Fidelity says.

Other adjustments such as "spread, "margin" and "asset fee" may trim gains even more.

The indexed annuity thus offers a guarantee against loss of principal that investors don't get in the stock market, the chance of earning more than with traditional fixed-income holdings, but less than with a pure stock bet like an index fund. Investors do not receive dividends as they would with an index fund. It's a trade-off.

It's a mistake to compare indexed annuities to the stock market, even if stocks have a role in their performance, says John Barnes, owner of The Annuity Assistant, an annuity brokerage firm. "Equity-index annuities were created to compete with certificate of deposit returns and other low-risk savings vehicles," he says. "Contrary to what many people think, (they) are not designed to compete with the returns of the stock market."

They don't replace bonds. Barnes says index annuities can add diversification to a broad portfolio that also has stocks and bonds, but he does not recommend using them in place of bonds.

Unlike a 401(k) and many traditional IRAs, there is no tax deduction on money put into an indexed annuity. Though there's no tax on gains until money is taken out, withdrawals of interest earnings are taxed as ordinary income.

Finally, unlike mainstream investments like stocks and funds, annuities do not qualify for the "step-up" in basis for heirs. An inherited annuity is taxed the same as one tapped by the original owner. With ordinary investments, heirs are taxed only on gains on top of the holding's value when inherited.

[See: 10 ETFs That Pay Sky-High Dividends.]

"Smart marketers on both sides of the business have learned that extremism works -- picking villains works" Johnson says. "Are (these products) right for everyone? No. Are they always bad? No. It all depends on each individual's situation, how such a strategy or product fits into their plan, and their capabilities as an investor."

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