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Investing Specialists

5 Key Questions to Ask Before Purchasing an Equity-Indexed Annuity

Annuities providing 'equity exposure with guardrails' have taken off in popularity, but the due diligence process is a headache.

Equity-indexed annuities promise what is the holy grail for many investors: a chance to participate in the equity market's gains along with a baseline guaranteed rate of return.

These products (sometimes called fixed-index annuities, to further complicated matters) are a hybrid between fixed and variable annuities. As is the case with fixed annuities, equity-indexed annuity purchasers are guaranteed a specific minimum rate of return. At the same time, holders of equity-indexed annuities can also participate in some of the gains of stocks. If stocks go up, you do better than the guaranteed rate, but if they go down the guaranteed rate serves as a buffer.

Many people are clearly compelled by the products' "stock investing with guardrails" promise. With yields ultralow, many investors are, out of a necessity, getting pushed out of cash and bonds and into the equity market. But they're still scarred by the memory of the tech wreck in the early 2000s and the market crash of 2007-09, so the idea of downside protection and a guaranteed rate of return resonates.

Indeed, with $34 billion in new sales last year, a 5% increase over 2011, equity-indexed annuities are a bright spot in the annuity industry, according to LIMRA, a life insurance trade group.

But the products are exceptionally complicated, featuring a host of contractual elements and terms that will be unfamiliar to most investors. And even for those who are willing to invest the time to understand what they're buying, it's extremely difficult to comparison-shop to make sure a given annuity is a good one. By the time you understand an equity-indexed annuity enough to purchase it, you could practically sell these products yourself.

That complexity and lack of transparency has prompted entities like FINRA, the self-regulatory body for brokers and exchanges, and the National Association of Insurance Commissioners to issue advisories on equity-indexed annuities, explaining the products and urging consumers to do their homework.

As you do so, here are the key questions to ask--and have answered to your satisfaction--before sinking your money into one of these products. (Remember, when it comes to your money, there's no such thing as a dumb question. If your advisor isn't explaining something clearly enough so that you can understand it, keep asking until you do.)

1) Do you know what you're buying?
First things first: I often run into investors who have annuities but actually believe they own something else, usually mutual funds. So the first step in the annuity due diligence process is to be aware that any annuity--whether fixed, variable, or equity-indexed--is a contract between you and an insurance company to provide you with income straightaway (an immediate annuity) or at some later date (a deferred annuity). That contract might specify that your returns will be linked to that of a given market benchmark, but you're not buying stocks, bonds, or mutual funds directly. The amount of payment you receive may be specified at the outset of your contract (a fixed annuity), it may vary based on the performance of underlying investments you've chosen yourself (a variable annuity), or it may vary based on how a market index performs (an equity-indexed annuity).

2) How will your returns be calculated?
Once you're clear on what an annuity is and how it's different from investing in traditional assets such as stocks and bonds, it's time to dig into the features of equity-indexed annuities specifically. To provide exposure to the equity market, most equity-indexed annuities track a given benchmark, often the S&P 500, with certain adjustments to the index's return. Here are some of the key issues affecting the return you'll actually receive:

  • Role of dividends: Equity-indexed annuities don't usually include dividends distributed by the index's constituents as part of their return calculations; they only track any price changes in the index's holdings. Given that dividends have accounted for a big portion of the index's total return over time (the specific amount varies by time period examined), that means that equity-indexed annuity purchasers will generally see significantly lower returns on the equity component than the index itself.

  • Participation rate: This is the percentage of the equity index's return that is credited to the annuity. If the market went up 10% and an annuity's participation rate was 80%, an 8% return would be credited. Some participation rates are fixed for the term of the annuity, while other annuities allow for the participation rate to change. Alternatively, annuities may charge fees in lieu of employing a participation rate, which also serves to reduce the return on the equity component. (Some annuities have both participation rates and fees.)

  • Index-tracking method: These annuities get really complicated when it comes to determining how index returns are credited to the annuityholder's account; annuities use multiple methods, including point to point, high-water mark, and ratcheting. Under the point-to-point method, for example, the amount your account is credited is based on the change in the index's value between two points in time--often at the beginning and end of the annuity term; this method doesn't factor in fluctuations in between those two points. (The FINRA Investor Alert explains the pros and cons of various indexing methods.)

  • Caps: These products often include a cap on the equity return you can earn in a given period, so if your return is 15% but your cap is 8%, you receive 8%.

  • Guaranteed minimum return: In the event the equity market tanks, these annuities typically guarantee that buyers receive 87.5% of the premiums they paid, along with 1% to 3% interest.

Here's the really sticky part. Once you understand how the returns of a particular equity-indexed annuity are calculated, it's extremely difficult to determine how the features of a given product stack up relative to those of other equity-indexed annuities. Of course, your advisor may have done some of that comparison-shopping for you, but unless your advisor is a fiduciary, he or she isn't required to ensure that any recommendations are the best options for their clients, but simply that they're suitable for them based on their knowledge of the clients' circumstances.

3) Do you have a long time horizon? Are you sure you won't change your mind or need access to your money?
One other crucial question to dig into is time horizon, because you might not be able to gain early access to money you've sunk into your annuity without incurring what's called a surrender charge. Oftentimes surrender charges will apply to assets withdrawn before 10 years have elapsed, but the length of the surrender-charge period will vary by contract, with some shorter and some longer. Charges for surrendering early in the life of the contract can run as high as 15%-20%, but then typically taper off, declining to 0% at the end of the surrender-charge period. (Some annuities allow buyers to withdraw a small percentage of their original contribution without triggering a surrender charge.)

And because you don't have to pay taxes on your gains from year to year, much like a traditional IRA, the Internal Revenue Service also treats annuities much like traditional IRAs when it comes to premature withdrawals. If you're younger than age 59 1/2 and you need to take money out of a tax-deferred annuity, you'll incur a penalty to do so. (You'll also pay taxes on your withdrawals at any age, as is the case with traditional IRAs and 401(k)s.) Those two layers of exit fees--the surrender charge and the potential 10% penalty on withdrawals before retirement age--argue for triple-checking that your time horizon is adequately long before signing an annuity contract.

4) What safeguards are in place?
Because an annuity is a contract with an insurer to pay you a stream of income, an essential part of the due diligence process is to investigate whether the insurer can keep up its end of the bargain. Prominent agencies that rate insurers' financial strength include Standard & Poor's, A.M. Best, Fitch, and Moody's. These entities vary in the type of free information they make directly available to consumers, and financial-strength ratings may also differ from firm to firm. As my colleague Adam Zoll discussed in this article, savvy consumers should look for high financial-strength ratings from more than one of the ratings agencies before opting for a given annuity.

Another part of the due diligence process is to acquaint yourself with what backstops exist in case your insurer runs into financial trouble. Large-scale insolvencies have been extremely rare in the life insurance industry, and all 50 states have guaranty associations to make clients whole if a company should run into trouble. That said, the backstop will be subject to coverage limits dictated by each state, so if you're sinking a large amount into an annuity, it will pay to diversify across multiple contracts with multiple firms to reduce the risks of any one company running into financial trouble.

5) Have you investigated other tax-sheltered wrappers?
Equity-indexed annuities, like variable annuities, have tax benefits: They allow your money to compound on a year-to-year basis without you having to pay taxes on the investment gains. And assuming you put aftertax dollars into the annuity, when you begin withdrawing money, you'll owe taxes on the investment gains in the annuity, but you won't owe taxes on your original contribution amount. Contributions to traditional 401(k)s and deductible IRAs, by contrast, receive the opposite treatment: You won't pay taxes on your initial contribution, but the whole 401(k) kitty--both the contributions and your subsequent investment earnings--will be taxed when you begin withdrawing the money.

At first blush the tax treatment of 401(k)s and annuities would seem to be a wash. Where it makes a difference, though, is if you expect to be in a lower tax bracket in retirement than when you were working. If that's the case, you're better off investing in a traditional 401(k) or deductible IRA, where contributions reduce your taxable income in the year in which you make them, rather than enjoying the tax break on annuity withdrawals when you're retired and it's worth less to you. Meanwhile, if you're convinced that your tax bracket is apt to be higher in retirement than it is while you're working, you're better off making contributions to either a Roth 401(k) or Roth IRA. You contribute aftertax dollars to a Roth, but your investments compound on a tax-free basis and withdrawals are also tax-free. The bottom line is that if tax reduction is a key goal for you, you're better off maxing out traditional IRAs and 401(k)s before turning to an annuity.

See More Articles by Christine Benz