There is nothing spookier than an equity indexed annuity (EIA). The National Association of Securities Dealers and the Securities and Exchange Commission have even issued advisories. Just last week, a cold caller got my office number and tried to lure me by saying, "People are making a lot of money selling equity indexed annuities."

If it sounds too good to be true .
EIAs sound too good to be true. Unsuspecting (foolish, with a small f) investors fall for the siren song about getting the return of the stock market index without the risk of loss. Usually, there is a "guaranteed" rate of return. Let's take a Foolish (with a capital F) view of what's inside that guaranteed rate. Your yield is based on an index, usually the S&P 500. But don't think it will approximate a SPYDER (AMEX:SPY). There is a "participation rate" that will lower your gain. For example, if your participation rate is 80% and the index returns 10%, your gain is only 8% (80% of 10%).

There are also "caps" that limit any growth to a predetermined point. For example, the S&P 500 returned more than 25% in 2003, but EIA investors likely received no more than 10%. And the historical rate of return of the S&P includes dividends, while many index annuity benchmarks do not. Plus, miscellaneous administrative charges lower an EIA's return. Pretty soon, that newly found romance starts looking like A Nightmare on Elm Street.

There is a guarantee, but it's not the same as the yield on a CD. In some cases, it is available as only a death benefit, or only those who choose to annuitize receive it. The promise may be worthless if you need your money before the surrender period expires. Surrender charges can be as high as 10% in the early years of an EIA. Boo!

Don't leave so soon; our Halloween party is just beginning. Unfortunately, when you buy an EIA, you forgo the favorable taxation of long-term gains. Any gain in an annuity is taxed as ordinary income. A guarantee that many investors unexpectedly receive is that they will be paying the maximum tax rate with an equity indexed annuity -- very small-f foolish. Another scary surprise is that there is no "step up" in basis at death with an EIA.

An annuity can provide a lifetime stream of income and can be a capital-F Foolish investment choice under the right circumstances. But equity indexed annuities are like the horror flick Poltergeist: Bad things just keep happening. Professionally speaking, I have yet to see a situation when an EIA was in the best interest of the client, and "people are making a lot of money selling them." Spooky!

Buz Livingston, CFP, appreciates your feedback.

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