Indexed annuity: Buyer beware

An equity-indexed annuity may seem like a can't-lose proposition, but proceed with caution.

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By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

NEW YORK (Money) -- Question: I'm 75 and I'm considering buying a fixed indexed annuity as a way to preserve my nest egg. Do you think this is a good idea? --William Frazier, Peachtree City, Georgia

Answer: I can understand why a fixed indexed annuity -- better known in annuity circles as an equity indexed annuity, or EIA -- might seem an ideal safe haven for your retirement stash.

After all, on the surface EIAs look like an all-gain-no-pain proposition. By pegging their returns to a benchmark like the Standard & Poor's 500 index, they offer you the chance to participate in the gains when the stock market goes up. The more the index rises, the higher your return.

At the same time, however, they protect you from fallout when the stock market drops by giving you a guaranteed minimum return, usually between 2% and 3% a year.

What possibly could be wrong with that?

Well, a few things. One is that you don't get the full stock-market upside. EIAs don't include stock dividends in calculating their gains, which means you can be giving up a significant share of stocks' payoffs over the long term.

EIAs also limit your upside in other ways. Most give you only a percentage of the increase in stock prices, say, 70%. Others may simply cap your potential gain, relegating you to a maximum return of, say, 7% in any one year regardless of how well the index does.

Figuring out what your gain might actually be can also be quite a challenge because EIAs employ so many different, and arcane, formulas to calculate their returns. Instead of just measuring the percentage change in the S&P 500 index over a period of time, for example, some use systems that involve averaging the monthly closing prices. Others calculate the increase in the index and then apply a margin or "spread." So, if the S&P 500 rises, say, 9% and the spread is three percentage points, you would give up a third of the gain and collect just 6%.

But maybe you're not concerned about missing out on potential return. Maybe you just want to be sure your money is safe and accessible. But there are issues you should be aware of on that front too.

For example, you may have to pay a hefty penalty to get at your money. Most EIAs charge surrender fees that in some cases can start as high as 15% and take 10 to 15 years to disappear. To be fair, many, if not most, EIAs do allow you to withdraw up to 10% of your money penalty-free each year. Still, it's possible that you might not have completely unfettered access to all the money in your EIA until you're well into your 80s or even until you hit 90.

But are they safe?

As far as the safety of your money and the guaranteed return is concerned, both depend on the financial security of the insurer that issues the annuity. No insurance companies have failed as the result of this financial crisis, at least to date. Still, around the time the federal government had to come to the rescue of giant insurer AIG last year, I got a lot of questions from worried investors who had retirement savings in the annuities of AIG and other insurers. Virtually all these people desperately wanted out, but the problem was that many would have to fork over a big surrender charge to leave.

There are a number of ways you can mitigate the risk of an insurer going under. You can stick to highly rated companies and spread your money among annuities with different insurers. There's also a state safety net for annuities and insurance policies.

Still, you still might want to think about how you would feel if we had another AIG-type situation and you had a big chunk of your savings in an insurer that you felt was vulnerable -- and a surrender charge standing between you and the exit door.

Given the complexity of these investments, their lofty surrender fees and their inherent high costs (stemming in part from the very generous commissions they pay to the people who sell them), I think you're better off just staying away from them.

If it's security you're after for your nest egg, I think you're better off investing your money in a conservative blend of CDs, bonds and, to the extent you still want some growth to maintain your purchasing power in the face of future inflation, a small dollop of stocks. This way, you'll avoid the costs and hassles of EIAs. And you should be able to gain enough stability to allow you to sleep at night and still have access to your money.

If you're not already aware, there's one more thing you should know about EIAs -- namely, they have a long and sordid history of being sold in a variety of misleading and abusive ways. Over the years, a variety of regulators have issued warnings and alerts about EIAs, with mixed results.

In an attempt to enhance the oversight of these controversial vehicles, the SEC passed a rule in December that gives the agency the authority beginning in 2011 to regulate EIAs as securities. Previously, EIAs had been considered insurance products falling under the jurisdiction of state insurance departments.

Given the SEC's less-than-impressive performance in the Bernie Madoff case, I'm not going to predict that putting EIAs under the SEC's purview will shield investors, particularly older ones, from all the problems often associated with EIAs. But I do think the standards for selling securities are generally tougher than for insurance products. So assuming this rule does go into force -- a group of insurers and marketers has already sued to block it -- I'm cautiously hopeful we'll see better disclosure for EIAs and fewer abuses in the years ahead.

In the meantime, I suggest that anyone considering an EIA take the time to understand how the product actually works, what its downsides are and, especially, what happens if you want to get out. If you're still tempted to go ahead, I recommend that you at least consider talking to an adviser who doesn't make his or her living selling EIAs to see if there's a more cost effective and less restrictive way to get the combination of safety and return you need.

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