Capped Returns

• The equity index annuity is often marketed with a basic explanation: "a minimum guarantee if the market is down and upside when the market goes up." Unfortunately, the upside is not easily understood. You are tied to one index, often the S&P 500. There is a cap on how much you can get when the index is up. You don't get the exact return the index gets, you get a participation rate. The participation rate may be 60 percent of the index annual return. So if the index does 10 percent, you only get 6 percent. This may be 8 percent; even if the index is up 50 percent, you are capped at 8 regardless of whether the participation rate would have been 30 percent.
  
  

Caps and Fees

• In order to give you a minimum guaranteed rate, the insurance company offering the annuity needs to make sure it will remain solvent in market down years. This is the reason for the participation rate and return caps. More so than that, index annuities maintain higher administrative fees. Fees are subtracted from your annual return. If the index annuity caps you at 8 percent annually and you have 2 percent in fees, your realized return is only 6 percent. That is when the market index exceeds 10 percent. If the index only earns 3 percent, your return would only be 1.8 percent. Depending on the annuity terms, you may be assessed fees or you may move into the minimum guarantee; each annuity is different.
  
  

Confusing Terms

• If understanding the basics of caps and participation rates isn't confusing enough, there are other terms you need to understand to know when and how your rate of return is computed. You may be told your money is mimicking the index, but the fact is your return is computed on one of three indexing methods. This may be an annual reset, the high-water mark of the year or a point-to-point method. The annual reset looks at the calendar year and is probably the closest to mimicking the index. The high-water mark takes the highest point the index reached in the year, while the point-to-point looks at the index from anniversary date to anniversary date.
  
  

Considerations

• Investors need to look at all aspects of an index annuity to fully understand whether it is appropriate or not for personal investment needs. Look at the length of the annuity and your age. If the annuity doesn't offer the necessary liquidity features you need, it will lock your money in with high penalties and fees. Surrender charges on index annuities tend to be higher than other annuities, getting as high as 20 percent to discourage early distribution.