More drawn to annuities that offer safety with stocks

Can you link the returns on a savings instrument to the stock market and still call it a safe? Surprising as it may seem, you can if you're promoting a type of fixed annuity that promises savers the best of both possible worlds: participation in the stock market's potential growth while avoiding any capital losses.

A creation of insurance companies, equity index annuities (EIAs) guarantee a minimum rate of interest and enable investors to earn extra interest based upon the performance of a securities market index, typically the S&P 500 index. Unlike certificates of deposit, the interest payout is tax-deferred during the annuity's accumulation period, generally seven to 10 years. EIAs also offer protection against loss of principal, a key selling point that also differentiates them from variable annuities.

This hybrid financial product is not legally designated as a security, and therefore isn't regulated by the SEC. That's because an insurance company guarantees the principal amount of the premium and the interest credited to the contract. Variable annuities, by contrast, are deemed securities because the account values fluctuate with the market performance of the underlying equities.

"Indexed annuities are an appealing niche product for consumers looking for the safety and features of a fixed annuity but with the potential for higher yields," says Ken Nuss, president of Annuity Advantage.com, an annuities marketer in Medford, Ore.

Sales of EIAs now account for about a tenth of the $218 billion annuity market. Investors scarred by the 2000-2003 bear market helped propel EIA sales to $23 billion last year, a 66 percent jump from 2003, according to Compendium Advantage, an annuities consulting firm in St. Louis. It forecasts EIA sales to top $28 billion this year.

Sales have also been spurred by the narrowing spread between interest rates paid on traditional fixed annuities and CD rates. Fixed-annuity rates, determined primarily by bond yields earned by insurance companies, have hardly budged over the past year. CD yields, on the other hand, have risen in step with the Federal Reserve's steady increases in the Fed Funds rate over the past year.

In today's world of subdued returns, EIAs are very competitive with other long-term savings instruments, says Jack Marrion, president of Advantage Compendium. Indexed annuities were basically designed to deliver returns averaging about 2 percent or so higher than fixed annuities and they've been successful in doing so, he says. For the 12 months ended July 30, returns on index annuity contracts bought one year earlier ranged widely from 4.5 percent to 11.2 percent. That nevertheless compares favorably with average returns over the same period of less than 2 percent for CDs and 5 percent for bond mutual funds, Mr. Marrion adds.

The investor profile

Index-annuity buyers typically come from two camps, says Mr. Nuss. The first consists of conservative investors whose incomes have been squeezed by the low interest rates available on traditional savings instruments such as CDs. The second are risk-averse mutual-fund investors who fear they might not recover from a loss of principal during a bear market. Most of the latter group are seniors with substantial assets who are close to or already in retirement. "They are looking to earn 6 percent to 9 percent a year on a portion of their assets with no downside risk. They won't lose principal if they hold the contract through the surrender period, even if the stock market and index falls every year," Nuss adds.

What to watch out for

But the capital preservation benefits of EIAs come at a stiff price, say some financial planners. Indexed annuities have a "wonderful marketing story," says Robert Nestor, principal of Vanguard Retirement Services. But the products are hard for investors to assess and compare, and have high surrender charges for those who don't stay the course, he says.

These early withdrawal charges can range from 5 to 10 percent of the amount invested, depending on how long the contract is held. In addition, he notes, investors give up a lot of flexibility for the promise that they won't lose any money.

The formulas used by insurers to credit interest to an EIA owner differ widely. Most policies permit investors to share in a major portion of the increase in the stock market, sometimes 70 percent or more. The participation rate, which doesn't include dividends earned, determines what percentage of a stock index's rise will be used to figure the interest payout. For example, in the case of a 70 percent participation rate, a $100,000 investment with an index rise of 10 percent would credit an annuity with a 7 percent gain, or $7,000 for the year. Many policies also impose a "cap" rate that places a ceiling on how much the account can grow each year. The cap rate varies by the length of the contract, but generally ranges from 6 to 12 percent.

EIAs are offered by more than three dozen insurers, including such well-known names as Allianz, Allstate, ING, Jefferson-Pilot, and Sun Life Assurance of Canada. Each policy, warns Nuss, has "its own twists," and should be examined carefully. Among his tips for prospective buyers:

• Since EIAs are sold mainly by insurance agents, make sure you consult one who has compared a variety of offerings and understands all the interest- crediting methodologies.

• Don't put all your money into a single contract, especially sums over $100,000.

• Lean toward contracts with a shorter term, preferably 10 years or less. That will allow you to reevaluate your financial position sooner if personal circumstances change.

• Be wary of any policy that requires mandatory annuitization at the end of the term. A lump sum payout option affords greater financial flexibility.

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