Index Annuities: Complex, Aggressively Sold Investments

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 With index annuities, these charges could be 18 percent of the amount withdrawn, or even higher.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.)

In many states, all a salesperson needs is an insurance license, which many regard as being far easier to get than a securities license. Considering the tremendous sales pressure that the high commissions generate, there's a good chance you may be approached. So it's important to understand how these products work.

Things to look for include:

Penalty-free withdrawal. Some index annuities allow you to withdraw a limited amount of your initial investment each year without paying a surrender penalty. This flexibility takes some of the angst out of decisions about whether to buy one of these products and, if so, how much to invest.

Cap rates. Most index annuities come with a cap on the amount of returns you would get on your investment over a set period. If the index does better than the cap, you get the cap rate only. Insurance companies, which typically set the cap rate at levels that are profitable for themselves,

Participation rates. These call for annuity buyers to get a fixed percentage of the index's increase each year. Again, the insurance company calls the shots on this by retaining the option to reset the rate annually. Some index annuities carry both a participation rate and a cap rate. (Insurance companies take their management fees out of returns above these rates, so the amounts of these fees are extremely difficult to distinguish.)

Financial strength. When you buy any type of annuity, you're essentially lending money to an insurance company for repayment with interest (minus fees). So you need to check on the long-term financial strength of these companies to assess risk. A good way to do this is to check the company's strength rating with A.M. Best

Even if you fully understand all of the features of an index annuity, it doesn't answer the question of whether a particular product is right for you. The reason the SEC tried to regulate this product was because they are frequently sold to people for whom they aren't suitable.

All too often, people are persuaded invest every dime they have, only to regret it down the road when they need large amounts to buy a retirement home or pay bills. Or they may discover they've made choices that work against their overall investment strategy regarding taxes and interest rates.

Whether any index annuity is right for you depends on many variables, including your age, income, existing portfolio, risk tolerance and total financial picture.

So when your tax preparer — after getting a clear view into your finances from your tax return — suggests an index annuity, ask him or her for a written analysis explaining why this product would work for your situation.

If the preparer won't provide this, walk away. If he or she will, then you should analyze it, preferably with help from an independent financial advisor.

Also before buying, be sure to ask the salesperson how much he or she would get as a commission. This way, everyone understands the motivation for the sale.

Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group ( He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at