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The surprise in the perfect investment
A popular investment promises the upside of stocks without the downside. My advice: Don't bite.
September 27, 2005: 2:24 PM EDT
By Walter Updegrave, MONEY Magazine

NEW YORK (MONEY Magazine) - Would you be interested in an investment that lets you cash in on the stock market's gains but promises you won't lose a cent if stocks plummet?

Of course you would, especially if you're investing for retirement and want to hold on to your savings, even through the kinds of devastating losses investors suffered when the stock market hit a wall back in 2000.

This is exactly why so many investment firms these days are wooing you with a special breed of CDs and annuities designed to let you ride the market up while protecting you from downdrafts.

The latest addition to this all-gain, no-pain approach is the MarketSafe CD, which St. Louis-based EverBank began selling over the Internet in July. Major investment firms such as Merrill Lynch and Wachovia Securities peddle similar "index" or "market linked" CDs, while insurers and many brokerage firms sell an annuity version known as an equity-indexed annuity.

This "upside without the downside" pitch has apparently found an audience. Sales of equity-indexed annuities have more than doubled in the past two years. But the real question is, Should you buy?

I say the answer is an emphatic no. The closer you look at these investments, the more they appear to be gimmicky come-ons that don't deserve a place in your retirement portfolio. Here are the reasons I believe you should pass.

The gains are limited

First, a quick primer on how these investments work. They typically pledge that you will share in the gains of a market benchmark like Standard & Poor's 500-stock index and guarantee that you will earn at least 1 to 3 percent a year even if stocks tank.

The firms that offer these seemingly sweet deals usually use a variety of sophisticated investing techniques, such as combining zero-coupon bonds and stock options, to fulfill their promise to investors, lock in a profit and protect themselves from risk.

Seems like a win-win, but here's the problem: When you add the costs of these techniques to the expense of marketing the products to the public, the potential rewards that can be passed on to you are dramatically reduced.

Although firms that sell index CDs and annuities make a big deal of the opportunity for outsize gains, the truth is that there's a lot less "up" in their upside than you might think. For one thing, stock dividends usually aren't counted toward your returns. So from the start, you're giving up the two percentage points or so a year that dividends contribute to the market's total return these days.

But that's just the beginning. In some cases, the return you get is subject to a "participation rate" that limits the portion of the market's gains that are passed on to you.

For example, one version of the American Equity Investment Life Insurance Co.'s Compass Select index annuity recently set a participation rate of 55 percent of the S&P 500's gain each year. So if the S&P climbs 26.4 percent, as it did in 2003, you'll earn just 14.5 percent and forgo almost 12 percentage points of gain.

Other companies may promise you 100 percent of the market's advance but then slap a cap on what you can earn. Schwab's Index Rewards annuity, for example, currently limits your annual gain to 6.5 percent if you choose an annuity with a five-year term, or 8 percent if you sign up for 10 years.

Complicated finances

It gets worse. You practically need a Ph.D. in finance to understand the way some companies calculate your return -- and that calculation can be costly.

Take the averaging method that EverBank uses for its MarketSafe CD. Instead of simply passing along the increase in the S&P 500 from the time you buy the CD until it matures, EverBank uses an average of the closing price of the index every six months over the CD's five-year term to compute your gain. (Got that?)

Turns out that while this approach can soften the impact of falling stock prices, it can also shave 50 percent or more off the market's gain during periods of steadily rising prices.

The ultimate effect is that over long time periods -- say, five years or more -- the return you earn from an index CD or annuity will very likely come in well below what you could have earned by holding a diversified portfolio of stocks and bonds.

Indeed, in the 30 overlapping five-year periods from 1970-74 through 2000-04, a conservative mix of 50 percent stocks and 50 percent bonds would have outperformed the MarketSafe CD all but three times, those three exceptions being periods that include the bear market years of 2000, 2001 and 2002.

What's more, the fifty-fifty mix did not suffer an actual loss in any of those five-year periods -- which goes to show that a diversified portfolio that includes stocks and bonds not only gives you a shot at much bigger gains but also offers plenty of downside cushioning.

The protection from losses has cracks

Okay, but maybe you're supercautious. At least with an index CD or annuity, you can be absolutely sure you won't get back less than you invested, right?

Not quite. The guarantee applies only if you hold the investment to maturity, which is typically five years for index CDs but often 10 or more years for annuities.

Many products will allow you access to your money in emergency situations such as contracting a terminal illness or entering a nursing home, and index annuities usually let you pull out as much as 10 percent of your investment each year. But if you cash out early because you need your money for some other reason, or you simply want to change your investment strategy, all bets are off.

In the case of index annuities, an early exit will trigger a surrender charge, essentially an early-withdrawal penalty. Surrender charges usually start at 7 to 10 percent and decline each year until they disappear after seven to 10 years. But sometimes, as with the Conseco FPDA-500 annuity, they can go as high as 20 percent and last as long as 15 years.

You can take a hit on taxes

Index CDs and annuities also come with a big tax disadvantage. Invest in a mutual fund that buys and holds stocks for the long term, and the majority of your return will likely be taxed at the rate for long-term capital gains, which maxes out at 15 percent.

All gains in index CDs, by contrast, are interest income, which can be taxed at a rate as high as 35 percent. The same goes for index annuities, although gains aren't taxed until you actually withdraw them.

With index annuities, however, you could face another nasty little tax twist: If you're under the age of 59 1/2, any gains you pull out of an annuity are hit with an additional 10 percent penalty tax, which means the total tax tab could climb to 45 percent.

If you're dealing with money in tax-deferred accounts like IRAs, the tax issues are moot since all gains in such accounts are taxed at ordinary income rates when you pull the money out. But if you're investing outside such accounts, you're effectively turning long-term capital gains taxed at the lowest rates into interest income taxed at the highest rates, which can dramatically reduce the amount that ends up in your pocket.

Add up the disadvantages -- the limited upside, penalties if you tap your account early, the higher tax rate on gains, the mind-numbing complexity of some of these vehicles -- and frankly, I don't see why anyone should take the bait.

The price of the safety these investments offer is simply too high: You're giving up too much return. And by creating a diversified portfolio of stocks and bonds, you can pretty much duplicate the downside protection of index CDs and annuities while giving yourself a much better shot at the higher returns that you'll need to maintain your standard of living over a long retirement.

So next time you're the target of a pitch about some fancy-schmancy CD, annuity or other investment that promises hefty gains with little or no risk, ignore it and remember this: Gimmicks don't make good investments.


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