Pitfalls Inherent in Equity-indexed Annuities

An equity-indexed annuity(EIA) is a special type offixed-rate annuity. It paysa lower guaranteed ratethan an ordinary fixedannuity. For example, it may pay 1.5%to 3% a year. In return, it pays a higherrate if a stock market index performswell in a particular year. However, if themarket falls during the year, you won'tlose anything; your return will be zerofor that year. And like all annuities, EIAearnings are tax-deferred, so you won'tpay taxes until you withdraw money.

EIAs have various crediting methods.For instance, a contract may call forcrediting 50% of the market's profits.So, if the S&P 500 is up 15% for theyear, you'll be credited with a 7.5%rate. Many EIAs have rate caps, whichmean that you won't earn more than acertain amount—say, 9%—even if theindex is up 30%. While EIAs soundappealing, the following are some of thedownsides of EIAs:

•Complexity. Every EIA has a differentcrediting method, and those finedetails can make a big difference inyour return. Even the simplest EIA iscomplex, but some are so complicatedthey make your head spin. It's challengingto understand how EIAs workand even harder to compare them.How can you tell if an EIA you're consideringis one of the best ones? It'salmost impossible to know.

•Lack of access to your moneyand withdrawal penalties. The big"if" with EIAs is that the minimumreturn is guaranteed only if you holdthe EIA to maturity. If you don't, allbets are off and withdrawal penaltiescan last up to 10 years. If you needyour money before the surrender periodis up, you'll have to pay a stiff withdrawalfee, and you may not get theguaranteed minimum rate.

•Big commissions and fees eatup returns. Whether you invest a littleor a lot in an EIA, the agent earns thesame commission—up to 15% is typical.You don't pay a sales charge, andit's ultimately deducted from yourreturn. The same is true of the insurer'shefty management fees and profits.While EIAs do provide some advantages,physicians planning for retirementcan pursue other options. You canaccomplish the same things as an EIA,but much more cost-effectively andwithout tying up your money by pursuingthe following three EIA alternatives:

•50/50 stock/treasury mix. Considerputting 50% of your nest egg intreasuries and 50% in conservativestock mutual funds. You'll have a guaranteedreturn on half of your moneyand growth potential with the otherhalf—and it's all 100% liquid. Anotheradvantage is that a portion of mutualfund dividends (ie, the portion generatedby qualified stock dividends) aretaxed at a maximum 15% rate, as arelong-term capital gains distributions.

•Variable annuities. Most variableannuities now offer guaranteed lifetimeincome options or withdrawal optionsthat help cushion against market risk.And while a variable annuity can producea negative return during any givenyear, you get the full benefit when themarket is up, instead of just a portion.The best variable annuities have reasonablemanagement fees. Some that aresold by financial advisors have no mortalityand expense fees—just an asset-managementfee, making them as cost-effectiveas mutual funds.

•Fixed-rate annuities. Fixed annuitiesprovide a guaranteed tax-deferredyield without gimmicks. Ifyou want to guarantee some of yourprincipal, you can, of course, put partof your money in variable annuitiesand part in fixed annuities.Before you put your money into anEIA, consider the alternatives carefully.The more you look under the hood, theless attractive EIAs will be.

Frank Congemi is a financial advisor whoworks with many physicians in severalstates. He lives in Deerfield Beach, Fla, andhas an office in Queens, NY. He welcomesquestions or comments at 800-228-2309 orfrank@frankcongemi.com.