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:

Stock

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.

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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.