Crashproof funds? Don't count on it

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(Money Magazine) -- In a year when stocks have sunk more than 40% and even supposedly safe bond funds are down, all you probably want is a little peace of mind -- or an investment that won't sink with the rest of your portfolio.

Don't look now, but brokers and insurance salesmen know exactly how you feel. This explains why sales of equity-index annuities (EIAs), insurance products that promise you some of the gains of the stock market but none of the losses, surged more than 20% this past spring.

"Fear is driving sales of a lot of these annuities," says New Jersey financial planner Chris Cordaro. "Salesmen will push them harder, and I'm sure they'll get more purchases because of what we've just gone through."

In the past, Money has frowned on these investments because of their overly complicated terms and steep costs. But given the new push for EIAs -- and fears of further market losses -- we thought this was a good time to revisit these products.

Our conclusion: While some investors, like those who are so scared they're putting every cent into cash, might find them a useful alternative, from this point on you'll likely be better off building a diversified portfolio without all the fees and restrictions that come with an annuity.

EIAs didn't garner much attention in the past because they're designed to protect you from market losses over long periods, typically more than a decade. But for an entire generation, equities just didn't lose ground over such a lengthy stretch.

That is, until recently. This decade highlights the usefulness of EIAs, proponents say. In 2000, had you put $100,000 into the index annuity shown in the chart above, your account would have grown to $160,000 at the start of 2008. Had you invested the same amount in an S&P 500 index fund, your money would have shrunk to $75,000.

EIA critics, however, point to the steep fees many annuities charge. Even before the market tanked, equity-index annuities were under fire by state attorneys general and the Securities and Exchange Commission because of their high fees and commissions, which encourage salesmen to push them on investors who don't always know what they're getting into. It's critical to understand just how much you're paying for this peace of mind.

In theory, an equity-index annuity should be simple to understand. You invest a lump sum of money for a set time, typically 10 years or longer. In return you are guaranteed a minimum rate of return -- typically up to 3% a year. If the market rises more than the minimum, your annuity has the potential to grow, up to a point. Meanwhile, your insurer promises that your EIA will never drop in value.

In practice, though, these annuities are among the hardest investments to understand -- partly because their terms can change over time. "Some of these products might pay off, but even a Ph.D. in finance can't tell you if it's worth it, because the returns are almost entirely at the discretion of the insurance company," says Boston University economics professor Laurence Kotlikoff.

No two annuities are alike. They can differ in fees, length of contracts, sales restrictions and the range of market gains you can expect. Even two annuities that track the same index may not deliver anywhere near the same performance. Why? Some EIAs will base your returns on how well a stock index did between the start and end of the year. But others rely on more complicated -- and frankly, head-scratching -- formulas.

For example, some average out all the month-end closing values for an index and use that instead of the actual year-end level to calculate what you're owed. Since stocks tend to rise more often than they fall, this could cut your potential gains. In 2006 the S&P rose 13.6% based on the year-end index level. But if you averaged out the monthly closing levels, your gain would have been a more modest 5.6%.

Don't assume you'll earn the market's actual returns through an EIA. For starters, insurers won't count stocks' dividend yield when calculating your index returns. Right off the bat, that will shave around two to three percentage points a year in performance. Here are other things to consider:

Performance caps. Don't focus on just the guaranteed minimums. Many EIAs set a ceiling for what you can earn, regardless of how well stocks perform. For example, in 2003, when the S&P 500 rose 26%, an annuity with a performance cap might have limited your interest to only 8%.

Participation rates. Instead of a performance cap -- or sometimes in addition to one -- many EIAs set participation rates. So if your annuity has a 55% participation rate, you'd enjoy 55% of the market rise, which in 2003 worked out to around 14%.

A surrender charge. Unlike individual stocks, EIAs will penalize you for withdrawing money prematurely. Surrender fees vary. But if, say, you need to tap a $250,000 annuity with a 10-year surrender period in year five, you might be charged 5% ($12,500). You'll also have to pay ordinary income taxes, not the long-term capital-gains rate, on the gains. And the IRS will hit you with a 10% penalty if you're under 59½.

Factoring in all the caps and fees, the average annual return on an EIA over the past five years was around 5.6%, says Jack Marrion, a research consultant for the insurance industry. In other words, an investment that's often marketed as a safer way to own stocks delivered bond-like returns.

The real problem: Many investors with a long time horizon can afford to own riskier investments with the potential for greater gains. While you do need low-risk assets for short-term needs, the fees and penalties for early withdrawal make EIAs a lousy short-term solution.

There is a simpler strategy to get a guarantee. Say you have $100,000 to invest but you know that 10 years from now you'll need every last dime of that. And say you still want to participate in stocks. You could start by buying zero-coupon Treasury bonds. Because zero coupons don't pay interest annually but instead return your principal and the imputed income at maturity, all it takes is $70,000 to get back $100,000 a decade from now. Then invest your remaining $30,000 in an S&P 500 index fund. If the fund were to fall 10% over the next decade, your overall portfolio would still have gained 3% a year.

Keep in mind that if you'll be retiring several years from now, you won't need to tap your entire nest egg all at once. So don't assume that you need to commit to a guaranteed strategy.

Over long periods of time, a simple diversified mix of stock and bond funds will give you a decent amount of downside protection, plus long-term growth. Of course, today's market shows that a traditional balanced portfolio won't give you the guarantees that an equity-index annuity will.

But the fact is, you can't enjoy the market's full returns without assuming market risk. "There are products out there that will give you the illusion of having both," says Cordaro. "But if you're getting protection, you're paying for it."