Annuities providing 'equity exposure with guardrails' have taken off in popularity, but the due diligence process is a headache.
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By Christine Benz | 04-25-13 | 06:00 AM | Email Article

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.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

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.
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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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