An Annuity You Really Should Avoid

The pitch is compelling: Participate in the stock market's upside and avoid the downside. That's how sales agents who collect lucrative commissions peddle equity-indexed annuities. Their targets are baby-boomers who are trying to rebuild their nest eggs and are now fearful of the stock market and frustrated with bonds' low interest rates.

Most equity-indexed annuity contracts promise that you will never lose money, even if the market index declines. But these costly products give you only a portion of the market's gains, and their protection against loss is minimal. If you're looking for principal protection, consider buying a deferred variable annuity with guaranteed benefits (see Lock In Your Retirement Income).

Fuzzy math. Despite the title, equity-indexed annuities don't actually invest in the stock market. Your returns may be loosely based on a market index, but you get a lot less than investors in the actual index would receive because of caps on returns and other limitations.

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For example, if Standard & Poor's 500-stock index returns 26% this year, as it did in 2009, investors in some of the Phoenix Companies' equity-indexed annuities would receive just 6.5% or less -- fairly typical for these products. Some equity-indexed annuities offer higher caps but reduce your returns by other means, such as restricting your participation rate to 80% of an index's increase or subtracting a fixed percentage (a spread rate) from the index's return. Worst of all, these limitations can change even after you've purchased the annuity. Plus, you may be locked in to the investment for seven to ten years and pay a penalty if you cash out early.

Indexed annuities are regulated as insurance products, not securities, so they offer few of the usual required disclosures to help you decipher their fees, calculate performance or even figure out how the money is invested. And the new financial-reform bill would keep it that way; it bars the Securities and Exchange Commission from implementing a rule to oversee them. For more details, see the Financial Industry Regulatory Authority's investor alert on equity-indexed annuities at www.finra.org.

As the "Ask Kim" columnist for Kiplinger's Personal Finance, Lankford receives hundreds of personal finance questions from readers every month. She is the author of Rescue Your Financial Life (McGraw-Hill, 2003), The Insurance Maze: How You Can Save Money on Insurance -- and Still Get the Coverage You Need (Kaplan, 2006), Kiplinger's Ask Kim for Money Smart Solutions (Kaplan, 2007) and The Kiplinger/BBB Personal Finance Guide for Military Families. She is frequently featured as a financial expert on television and radio, including NBC's Today Show, CNN, CNBC and National Public Radio.