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Retirement Made Complicated


Equity-indexed annuities are getting perhaps the worst press and the most regulatory scrutiny of any financial product pitched to individual investors. The biggest knock on the annuities—which let you share in stock market gains with minimal risk of loss—is not the investment itself. Instead, it's the hardball sales pitches that critics say didn't adequately explain fee structures, especially the early-withdrawal penalties.

In fact, this year attorneys general in at least two states have filed suits against insurers, charging inappropriate sales tactics. And a federal judge in Minnesota certified a class action against Allianz Life Insurance Company of North America, the largest purveyor of such annuities, for faulty disclosures. Allianz says the suit is without merit. Watchdogs are making waves over industry tactics, too. "We have concerns about the way they are sold," says Elisse Walter, a senior executive at the Financial Industry Regulatory Authority, the securities industry's self-policing agency. "We're not condemning the product." That job falls to investment counselors. "They resemble a sucker's game dressed up to look like a free lunch," says John Gay, a financial adviser in Frisco, Tex. Gay says investors would be better off buying zero-coupon Treasury bonds and an ordinary index fund.

Replicating an annuity strategy may be cheaper, but annuities are convenient. Also, with an annuity, taxes are deferred until you cash out. In a broad sense, indexed annuities are riskier than fixed-rate annuities or bonds but less risky than variable annuities or stock mutual funds, says financial adviser Errold Moody, author of the book No Nonsense Finance. The no-loss feature can protect you from a stock market loss just at the point when you would need the money. "Maybe the statistics say you're better off owning a portfolio of stocks, but look at someone who retired in 2002 when we were in a bear market," says Moody.

Here's how the indexed annuity works. An investor buys a policy with a one-time purchase—typically a minimum of $5,000 or $10,000. The term may run from 4 to 12 years, and the payoff is linked to the stock market. The big selling point—one that gives it a lot of appeal to risk-averse sorts—is that the annuity's value doesn't decline if the market does. In fact, the annuity builds in a guaranteed minimum return, usually between 1% and 3%.

If this no-loss policy sounds too good to be true, it is. The annuity owner doesn't get all of the stock market's gains, and forget about the dividends. That's the giveback—in effect the insurance premium—that pays for the downside protection and the minimum guarantee.

Comparison shopping is a challenge. "The features vary so much from company to company, they can be tough to figure out," warns Moody. Another difficulty is that many insurance agents sell annuities from only one or a handful of companies. The Web site Annuityadvantage.com makes gathering info easier because it carries quotes on annuities from some 50 insurers. The site can connect users to agents licensed in all 50 states or directly with insurance carriers.

Interested? Here are the questions you need to consider before investing in an equity-indexed annuity.

How much market return do I get?

That all depends. Results are tied to the performance of a market index, usually the Standard & Poor's 500, but investors don't share in all of the index's gains. Many annuities now cap the return at less than 10% a year. In 2006, when the S&P was up 14% before dividends, a vast number of indexed annuity investors lost out.

Some annuities also use a "participation rate." That's the portion of the index gains you will receive—and it can range from 50% to 90%. There can also be a charge, the so-called spread, that deducts from the index's return, typically one to two percentage points a year.

All of these features have to be considered together. For instance, Midland National Insurance Mainstreet 4 annuity has a 100% participation rate, but caps gains at 7.5% a year. Equitrust Life Insurance Market Ten Bonus has a 55% participation rate, but there's no cap. Neither policy deducts a spread.

How is the equity index's gain calculated?

Originally, most indexed annuities simply measured the S&P's gain over the life of the annuity, a formulation known as "point to point," or they tacked each year's return onto the previous one, a technique called "annual reset." But sometimes the S&P is higher in the middle of the term or the middle of a year, so now some annuities, as a selling point, use the index's highest level, or "high-water mark." The trade-off can be a lower cap or participation rate.

What if I want to get out early?

Insurance companies pay salespeople up front and recover the commissions over time from annuity profits, so there's always a surrender charge for cashing out before the term is up. Such charges can be as much as 20% in the first year, with the percentage declining as the policy ages. Some go on for as long as a dozen years. An industry study considers seven years to be more reasonable. Best bet is not to invest any money you may need during the policy's term.

Who is behind the annuity?

Unlike mutual funds, an annuity is backed by an insurer's promise to pay, not by a portfolio of securities. If that insurer goes bust, the annuity will likely be worthless even if the S&P 500 is soaring. You can check an insurer's financial-strength rating at a host of Web sites: ambest.com, moodys.com, standardandpoors.com, weissratings.com, or dcrco.com.

What if I fell for an aggressive pitch?

Even if you think you've done a thorough job parsing the details and you buy an annuity, review your work. In most states, there is a "free look" period, typically 10 to 20 days from the date of purchase, that lets buyers opt out with a full refund.

By Aaron Pressman


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