Seeking a steady stream of income through index annuities

Q: What can you tell me about equity index annuities? I am a 73-year-old widow and need income. But my main concern is safety. I have an annuity earning 6.5 percent that will mature within the year. It is the major source of my income. Since I draw only interest and that interest will drop to 3 to 3.5 percent at maturity, it will not be sufficient. But I can't invest in anything that would keep me awake at night.
- J.P., Bakersfield, Calif.

A: First, a definition: An index annuity is a fixed annuity offered by an insurance company. It earns a minimum rate of interest and offers the potential for excess interest based on the performance of an independent stock or bond index.

The S&P 500 index is a popular benchmark with indexed annuities. Both principal and credited interest are protected from declines in that index, says Jack Marrion, president of Advantage Compendium, a consulting firm in St. Louis that does research on indexed annuities.

Mr. Marrion says the worst thing that could happen to such an investment is if the stock market drops during all the years you own it. Even then, he says, you'd still get back your initial investment, plus a little interest.

An index annuity is as safe as the insurance company that issues it, says Marrion. So before you invest in one, you need to find out from the seller how well it is ranked by independent rating services such as Fitch and A.M. Best.

If the insurance company does go belly up, the annuity contract is still an asset of the insurer. Typically in such cases, another insurer buys the annuity contracts of the troubled company and life goes on. Every state has a guarantee fund to protect annuity contract owners up to a certain limit if a company tanks.

It is possible to lose money if a company fails, but based on history that is unlikely, Marrion says. "The way I look at it is, my car is insured, my house is insured, and my life is insured. I'm not losing any sleep over these insurance companies, why should the annuity carrier be any different?"

Though he's a big fan of indexed annuities, Marrion advises not putting all of your money into one. You could have a period when the index goes down for two or three years - such as the last bear market - during which time no index-linked interest is produced.

To sum it up, index annuities have produced five-year returns that are very competitive with other savings vehicles, but the year-by-year interest depends on what the index does.

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