Have you heard of equity-indexed annuities (EIAs)? They promote the dual benefits of a guaranteed, minimum return (limited downside) with market returns (upside potential) based on an equity index. On top of that, you can even defer taxes for years until you withdraw funds. For the highly risk-averse investor who doesn't want to miss out on possible stock market gains, an equity-indexed annuity certainly sounds attractive.
However, there is no free lunch in investing, and that's especially true with EIAs. These products require considerable research, and they are appropriate only for investors who don't need to withdraw the money during the long life of the contract. They also require careful analysis of the risk of the issuer. And that tax break is great only until you withdraw from the annuity and pay ordinary income taxes on the gains, rather than the lower capital gains tax rates available on other investments.
Equity Index. Typically, EIAs use Standard & Poor's Composite Stock Price Index (S&P 500) as their index. This is a widely respected and useful index, but it lacks international diversification that a portfolio should contain. Furthermore, dividend payments from S&P 500 companies play an important role in the performance of the S&P 500 index, but these dividends might not be included in the calculation for crediting the return on the purchased annuity.Without dividends, EIAs often underperform the S&P 500 by one to three percentage points per year.
Rate of Participation. You'll never receive the whole market index return with an EIA. For example, if the participation rate is 80% and the index gains 10%, then the interest rate on the index-linked annuity will be 10% multiplied by 0.8, or 8%. Read the fine print, because it might get worse: your participation rate might not be fixed for the term of the annuity. Find out how it will be adjusted.
Cap on Interest. Some EIA contracts put a ceiling or cap on the rate of return to an investor. For example, if the cap is 7.5%, then the holder of the annuity in the previous example will get credited with 7.5%, not the 8% indicated by the participation rate.
Minimum Rate of Return, or a "Floor" on Interest. Typically, the lowest rate that an EIA can earn is 0%.
Administrative Fee. Annuities normally have annual fees of 1.5- 3% (sometimes more), which further reduce the return paid to the investor at the end of the contract.
Bottom Line: Do your homework, comparison-shop, and seek advice from a Fee-Only advisor before purchasing an annuity.
