Cents and Sensibility
Guy Steele

Be exceedingly careful
with equity-indexed

EVERY so often, a new investment product comes along and attracts a lot of interest from investors, but not a lot of scrutiny. That might be the case with "equity-indexed annuities." Sales of this insurance product have grown dramatically in recent years, but evidence may suggest that many investors do not know all the facts before they buy.

An equity-indexed annuity, or ETA, actually has characteristics of both fixed annuities, which pay a fixed rate of return, and variable annuities, whose returns depend on the investment options selected. An ETA provides a minimum guaranteed interest rate (guarantees are backed by the claims-paying ability of the issuing insurance company) combined with an interest rate linked to a market index, such as the S & P 500.

The ETA's interest rate is typically lower than that of a fixed annuity. However, due to the market-index factor, an ETA offers potentially higher returns than a fixed annuity -- along with a higher level of risk. On the other hand, an ETA is generally less risky than a variable annuity, but at the same time, its "upside" potential is more limited.

While the ETA may appear to have some attractive features, investors should take a closer look at an ETA before purchasing one by going to the NASD Web site at www.nasd.com and type in "equity-indexed annuities" in the search area.

Here are a few other items to consider:

» Complexity: An ETA is not a simple product to grasp. That's primarily because the return does not perfectly correspond to the market index to which the annuity is linked. Instead, the index-linked interest rate you receive will depend on the terms of the contract.

You need to understand the calculation used to determine what percentage of the index gain will be credited and what limits apply. (Most ETAs put a cap on the return you're allowed to earn.) There are also several methods used to determine the change in the index, which can affect the calculation. Finally, most ETAs only count the index gains from market price changes, excluding any gains from dividends. These variables mean that you could receive less than what you expect.

» Access to your money: If you cash out your ETA early, you may have to pay a sizable surrender charge (and a 10 percent penalty tax if you're under 59 1/2). Some ETAs also require you to forfeit your index-linked interest if you surrender your contract early or choose not to begin taking payments when the contract matures. Together, these charges can reduce, or erase, your return.

» Lack of regulation: Unlike variable annuities, ETAs are generally structured so that they are not registered with the Securities and Exchange Commission. And ETAs are primarily sold by individuals who are not registered to sell securities; these individuals may not look at your entire financial picture before recommending an ETA.

Do your homework before making any ETA purchase decision. If you're an annuity buyer looking for a guaranteed rate of return, you should probably consider a fixed annuity. If you want some equity exposure, then a variable annuity may be your best choice. If you owned both, you could get the guaranteed rate of return you need and the upside potential you desire.

See the Columnists section for some past articles.

Guy Steele is a financial planner and head of the Pali Palms office of Edward Jones. Send planning and investing questions to him at 970 N. Kalaheo Ave., Suite C-210, Kailua, Hawaii, 96734, or call 254-0688

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