The truth about 'can't-lose' funds

(Money Magazine) -- Question: I have heard about these annuities that promise "nearly" market based returns if the market goes up but a fixed positive return if the market goes down. How do they work "behind the curtains"?

The Mole's Answer: The products you're describing are known as equity-indexed annuities and the pitch goes something like this: "You get the upside of the stock market without the downside risk."

Ask Money Magazine's undercover financial planner a question. Send e-mails to: themole@moneymail.com.

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Sound too good to be true? It is.

Look, who wouldn't want to benefit if the stock market goes up but suffer no consequences if it crashes. These products prey perfectly on both of our investing emotions: fear and greed.

But let's go behind the curtains of equity-indexed annuities and take a peek.

There are an infinite number of variations of these products but the catch is always in the wording. For example, one equity-indexed annuity promises "100% of the average increase of the S&P 500 index."

Sounds clear right? But if the S&P rises 10 percent, you'll end up with only a 2.25 percent return.

How can this be?

First of all, the return of the S&P 500 comes from both dividends and capital appreciation (a fancy way of saying stock-price gains). And the investment company's sales pitch is referring only to the capital appreciation.

So if dividends provide a 1.7 percent return, the equity-indexed annuity will count only the 8.3 percent from stock-price gains.

There's more. The pitch also refers to "average increase," which is very different from the 10 percent or even 8.3 percent "total increase."

In this case "average" was defined as the simple average return for each month of the year. Now funds might return 1 percent or 2 percent for a few months, return 5 percent another, and then lose money for a bit. The index's total return at then end of the year could be 8.3 percent. But the average - adding up the monthly returns and dividing by 12 - could be more or much less. But it is mathematically likely to be half, or 4.15 percent.

In this particular product, the insurance company also charged a 1.9 percent fee deducted from the 4.15 percent average return, so the final earnings credited would be a measly 2.25 percent.

Equity indexed annuities often offer a cash bonus of 10 percent or more the minute you make a deposit. It's a great sweetener for a salesman to close the deal. Of course, they can afford it given the low returns.

Finally, if you decide you want your money back within a predetermined period - say, 15 years - the insurance company can charge you hefty penalties. Sometimes the details of those "surrender" fees are buried in the footnotes.

Be particularly cautious when you hear something that sounds too good to be true. Much as you'll want to believe it, your adviser may be using some emotional tactics to get you to sign on the bottom line. Before you do, I suggest that you:

• Ask your advisor to put in writing why he thinks this is suitable for you.
• Understand how the gains are credited. Ask what your return would have been in 2006, a year when low cost S&P 500 funds went up 15.6 percent.
• Read the entire document and know the length of time a surrender charge is levied and the amount of that charge, if you want your money back.

There are 64,000 flavors of these equity-indexed annuities and each has its own hooks and catches. There are participation rates, caps, spreads, surrender schedules and the like. I can't even begin to address each one.

I can, however, tell you what's behind every single one of these beauties. They are offered by insurance companies and these companies make money by investing your funds at a greater rate than they pay you.

Since nearly all of these insurance companies have the vast majority of their portfolios invested in fixed income, you should expect your return to resemble a fixed income fund less commissions, profits, and taxes. It's that simple. Behind the curtains are the usual smoke and mirrors designed to give the illusion of market returns without the risk.