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Beware ‘Miraculous’ Equity-Indexed Annuities

Editor’s note: “Financial Planner” is a new occasional column by the Rev. James G. Mentzer CLU, ChFC, a financial planner since 1985 and current director of planned giving for the United Methodist Foundation, Raleigh, N.C.

Retirement—we all look forward to partaking some day. And, we all pray that we will have the financial security then that will allow us to enjoy, rather than simply endure, those years. Yet most of us are less than clear about the best path for reaching this Promised Land.

One of the latest concepts seems nothing short of miraculous: an investment that allows one to enjoy the potential gains of being fully invested in the stock market without running the risk of losing principal. It’s called an “equity-indexed annuity” and if you haven’t received information about one, you probably will soon! In 2006 alone, consumers invested a record $27.3 billion into these annuities, according to Advantage Compendium, a research firm based in St. Louis that tracks the industry.

What makes the equity-indexed annuity unique is that its returns are tied in part to one of the stock market indexes, such as the Standard & Poor’s 500. When Wall Street performs poorly, the contract typically includes a guaranteed minimum return—often a 3 percent annual interest rate. On the other hand, when the equity market performs well, contract holders appear poised to reap the same benefits as those who are fully invested in the stock market.

This investment concept came into prominence after the post-9/11 collapse of Wall Street, when three years of significant losses in most of the major markets left folks saving for retirement shell-shocked. Thus, the promise of safety and security made by equity-indexed annuities sounded wonderful.

Unfortunately, the promises may prove too good to be true! Equity-indexed annuities are complex investments with confusing features and significant fees. To make matters worse, insurance agents often use aggressive sales tactics to promote these products. But to date, investors who expected these annuities to match stock market returns in strong markets have been greatly disappointed.

The returns for equity-indexed annuities are based on a contractual formula that determines what percentage of gain in the stock market in a given time period will actually be credited to the annuity contract.

For example, if the participation rate is 85 percent and the market index increases by 9 percent, the actual interest rate credited to your annuity will be 7.65 percent. However, many of these contracts exclude the value of dividends from the gains factored into the participation formula. And most impose a monthly or annual cap on your return, no matter how well the market does during that time period. What’s more, one typically pays an asset-management fee, which may range from 2 percent to 2.5 percent on top of the generous commissions paid to insurance agents. Thus, one’s effective annual return may end up appearing paltry.

To compound matters, equity-indexed annuities are long-term contracts with stiff penalties for early withdrawals. While most allow up to 10 percent of your original investment to be withdrawn on an annual basis without penalty, the surrender charges on amounts above that may be as high as 10 percent. And, when you finally can take distributions without incurring surrender charges, any investment gains are taxed at regular income rates, rather than the more favorable rates available for capital gains.

What might be a more viable alternative for pastors seeking to supplement denominational retirement plans? Most financial advisors would suggest that a simple portfolio of Treasury securities and a well-diversified stock mutual fund will allow you to enjoy comparable or better returns than an equity-indexed annuity without the complexities or the high expenses.

Both the Securities and Exchange Commission and the National Association of Securities Dealers caution investors to research fully any equity-indexed annuity contract before investing funds. If financial experts find these products so complicated, then the average clergy person would be well advised to explore other ways to invest for retirement.

This article represents the personal views of the author and should not be considered either professional tax or legal advice. If you have questions concerning your own situation, you are encouraged to consult your personal advisors. Got a general question dealing with financial planning? E-mail Mentzer at magazine@div.duke.edu.