Index Annuities: Complex, Aggressively Sold Investments

Sept. 19, 2011— -- Don't be surprised if your tax preparer or insurance agent tries to sell you an investment called an index annuity.

An index annuity is one where returns are linked to the performance of an index — a group of securities like stocks in the S&P 500. If chosen carefully and used properly, this product can help some people achieve their financial goals. But it is by no means a one-size-fits-all solution.

Buying any type of annuity is basically the reverse of buying life insurance. When you buy an annuity by turning over a large lump sum to an insurance company, this money draws interest over time. In return, you can elect to receive guaranteed monthly payments. Depending on the choices you make, these payments can continue for 10 years, 20 years or the rest of your life.

With some annuities, if, for example, you invest $100,000 and choose the "life only" option, you could elect to receive a monthly payment – say, $700 a month -- for the rest of your life. But, depending on the contract, the insurance company might keep the balance of your investment after you die; your heirs would get nothing.

With the same $100,000 investment, if you'd chosen "life with 10 years certain" you'd receive a lower monthly payment – say, $600 -- but this would be guaranteed for 10 years, whether or not you remain living. If you die during the first month of the contract, your heirs would receive the payment for nine years and eleven months.

So your age and your health are key factors in deciding whether to buy an annuity. Insurance companies typically do not require physicals. You can be a winner if you are in good health and live longer than the insurance company expects, according to life expectancy tables.

The guaranteed income stream may be the best reason to buy an annuity, especially in this uncertain economy; many people buy annuities to ensure that they don't outlive their assets. To limit the amount of the payments that they ultimately make, insurance companies naturally market these investments to older people.

Annuities are highly complex investments that often have distinct downsides for investors. Your access to your money is severely limited for an initial "lockup" period that could last 10 years or even longer, unless you pay a surrender penalty. With index annuities, these charges could be 18 percent of the amount withdrawn, or even higher.

One reason that the surrender charges for index annuities are so high is that insurance companies pay salespeople double-digit commissions. They need time to earn this money back on their portion of the returns from your investment.

And earn it they do. Index annuities are highly profitable, and these profits are rising with the astonishing sales volume: In the third quarter of 2010, sales topped a whopping $8 billion.

The reason for this volume: High commissions drive aggressive sales. You don't have to seek them index annuities; they find you. Another reason for the high sales figures: The barrier for entry to sell these products is low. Unlike those selling variable annuities – when your money is actually invested in mutual funds — vendors of index annuities aren't required to be licensed by the Financial Industry Regulatory Authority. (The Securities and Exchange Commission has tried to change this, but insurance company lobbyists won that battle.)