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Sometimes, an investment seems to offer the best of both worlds. But unless you look closely at exactly how that investment works, you may find out the hard way that things don't always work out as well as you hope they will.

Some of the most complicated investments you can buy involve insurance. On their face, insurance-related investments often offer the promise of generous returns without the full risk involved in regular investments like stocks and mutual funds. For hard-hit retirement investors still recovering from 2008's market meltdown, that sounds like the perfect combination. Yet because they're so difficult to understand, insurance-related investments can be expensive -- and cause some nasty surprises down the road.

Index annuities and you
Right now, rates on investments that offer principal protection, such as bank CDs, are extremely low. That's putting many savers in a bind; they need more income now, but they can't really afford to take the risk that most higher-paying investments involve.

That's where index annuities come in. Issued by insurance companies, index annuities feature interest rates that are tied to the returns of stock indexes like the S&P 500. But they also come with principal protection, guaranteeing a minimum recovery no matter how far the stock index may drop.

That combination of upside potential and downside protection is especially appealing after the market's gyrations over the past three years. The prospect of getting to participate in the excellent returns of bull markets while missing out on bad years like 2008 sounds like the perfect solution.

Bursting your bubble
Unfortunately, the reality doesn't work out that way. As an article at CNN Money recently explained, index annuities have some unappetizing features that make them a lot less attractive than they initially sound:

  • Caps limit the amount you can earn every year. With current caps around 4.5%, you'll mostly miss out on the great returns from years like 2009 and 2010.
  • Expenses can be extremely high.
  • Surrender charges of as much as 20% apply if you pull money out in the first 10 years.
  • Bonus payments can sometimes be taken back.
  • High commissions, averaging roughly double what other annuities offer, put financial advisors in a situation where conflicts of interest are almost inevitable.

But perhaps the most compelling argument is the extent to which insurance companies profit from these products. Consider the performance of the stocks of some of the biggest sellers of index annuities:


Index Annuity Sales, 2009

2-Year Average Annualized Return on Company Stock

Aviva (NYSE: AV  ) $5.4 billion NM*
American Equity Investment (NYSE: AEL  ) $3.0 billion 38%
Jackson National Life (indirect subsidiary of Prudential plc (NYSE: PUK  ) ) $2.2 billion 50.3%
Lincoln Financial (NYSE: LNC  ) $2.2 billion 27.3%
ING (NYSE: ING  ) $1.9 billion 6.5%

Source: CNN Money, Yahoo! Finance.
*Aviva's U.S.-listed ADRs have traded for less than two years.

Granted, index annuities aren't responsible for all of the success of these stocks -- although index annuity sales made up 92% of American Equity Investment's total business. And there's nothing wrong with insurance companies making a profit. By taking on the risk that so many of their customers were eager to get rid of, these companies have made their shareholders very happy. It's a good lesson that sometimes, it pays to assume risk -- and that getting rid of risk at all costs can create a huge opportunity cost.

Even more tellingly, some insurance companies have steered clear of index annuities. MetLife (NYSE: MET  ) and New York Life, for instance, don't sell index annuities, because they're too complicated and could disappoint investors.

Keep it simple
Overall, if you want a low-risk portfolio, you're better off keeping most of your money in FDIC-insured CDs and investing a modest amount in the stock market. Broad-market ETFs Vanguard Total Stock Market ETF (NYSE: VTI  ) or SPDR Trust make it easy to set the right mix for you, and it's much easier than trying to navigate the high fees and complicated provisions that most index annuities have.

It would be nice if investors could get the best of both worlds. Unfortunately, the complexity of index annuities completely outweighs any protection they offer.

High-return stocks are always in demand. But Jim Royal explains why you should avoid these 30-bagger stocks.

Fool contributor Dan Caplinger steers clear of danger. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy always ensures your satisfaction.

Read/Post Comments (5) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 20, 2011, at 9:57 AM, kimobrien wrote:

    Dear Mr. Caplinger,

    In your article, “Stay Away from These Investments,” you make a very interesting statement: “Right now, rates on investments that offer principal protection, such as bank CDs, are extremely low. That’s putting many savers in a bind; they need more income now, but they can’t really afford to take the risk that most higher-paying investments involve.”

    The value of index annuities is that they provide these people with a better solution than their current situation. In an index annuity, they have the potential to receive a considerably higher rate of interest than what they are receiving today, yet they are completely protected from the risk of loss if the index declines. For many conservative savers, this is a wonderful value proposition, one that has made these products increasingly popular year after year.

    Index annuities are not intended and never were intended to provide “the excellent returns of bull markets while missing out on bad years.” You, of all people, should know that no product could possibly provide that combination, for the only way to get that combination would be to have perfect knowledge in advance of which years will be bulls and which will be bears. It can’t be done.

    Regarding your analysis of insurer stock values, you conveniently ignore the fact that two years ago, the stock values of many financial institutions were at distressed levels as investors were questioning whether many of them could even survive. It would be much fairer to evaluate the growth in those stock values over the entire period that those insurers have written index annuities. I would not be surprised if many of those companies’ index annuity owners have fared better than their stockowners. But even if they didn’t, the index annuity owners took no risk whatsoever, whereas the stockholders endured dramatic gyrations in the value of their investment.


    Kim O’Brien, Executive Director

    The National Association for Fixed Annuities

  • Report this Comment On January 20, 2011, at 11:32 AM, fstolpman wrote:

    Mr. Caplinger, you start by saying that CD's and their low rates have put people into a bind, and then you end by recommending that people put their long term retirement money into CD's!! Index annuities were never intended to compete with the stock market gains, just offer the potential upside of some of these gains while securing the principal from ANY loss. CD's earn interest which is taxed, annuities grow tax deferred. But the main point is that fixed equity linked annuities are purchased to provide an income stream in the future, not be an agressive investment vehicle. A person can still invest the bulk of his portfolio in mutual funds, stocks, etc. With a guaranteed income stream for life plus social security, a person can actually be more agressive with his other investments than a person who has to liquidate assets periodically to live on. My indexed annuities have outperformed the S&P 500 over the last 10 years because I suffered NO losses in the down years. And I am very please with their performance (no so much my 401K and other mutual fund investments, even though they have come back substantially in the last 2 years.)

  • Report this Comment On January 20, 2011, at 6:47 PM, SFG1015bs wrote:

    Mr Caplinger

    You know what they say about opinions....

    All I see here is another biased, inaccurate, and I must say ignorant opinion expressed. On the one hand, I don't have the patience and time to respond to this kind of misguided, prejudiced journalism, yet on the other hand, I do feel compelled to vent my frustration over biased fools like you. OK, I feel a little better now. Croupiers like you are a double wammy to our financial system - you try to rob people of the truth while you have your hand out to profit from placing their bets. It's both sad and infuriating.

    Brian Singer

    Singer Financial Group

  • Report this Comment On February 01, 2011, at 4:14 PM, shawnfreeman wrote:

    Mr. Caplinger,

    I started out reading your article with some interest to see where you sided on Index Annuities. Then I got to the part where you referenced the article written by CNN Money and I knew immediately where you were headed. I would challenge the validity of the Money article with any broker out there. It was the worse excuse for truth that I had ever read. To use make believe product specs such as a 4% Cap with a 8% bonus over the past 10 years is ludicrous. If these figures actually exist, then I would like to know what bottom feeder company sold this investment. I have been writing Indexed Annuities since 2002 and until recently had never seen a cap lower than 5% on an Annual Pt to Pt Crediting Method. Also everyone wants to talk about how complicated these investments are, yet Variable Annuites, REIT's, and Mutual Funds issue 100+ page prospectus' to its clients. Also I believe it was just in the past few years that these so called experts were saying it was a good idea to put 15% or more in REITS. How's this advice looking today? Most REIT's today are totally void of withdrawals of any kind.

    Since 2004 I have placed nearly $20 million in FIXED (did you catch that FIXED) Indexed Annuity and I bet you EVERYONE of my clients would disagree with your statements.

    Also you stated 20% surrender penalties. Is this the whole truth you are telling or just partial. I believe it to be the partial truth. For example I know EQ has a surrender penalty of 20%, but you left out the fact that they give a 10% bonus that is VESTED immediately. Most companies today that give a 10% bonus have a vesting schedule. But there surrender penalties start at 10%. So please quit twisting your facts. If you need someone to proof your column before you go live with it I will be more than happy to help to make sure people are getting the facts from both sides.


    Shawn Freeman

    20/20 Financial Group

  • Report this Comment On May 21, 2015, at 5:45 PM, TBinSD wrote:

    Funny how all the rebuttal comments are from 'financial advisors' that more than likely selling these crappy products. EIA's are a great . . . for those that sell them and the companies that issue them.

    Tom Brenner CFP®

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