Pros & Cons of an Equity-Indexed Annuity

by Mack Mitzsheva

Investors often search for ways to increase their net worth. Investment options include high-interest money market accounts, stocks, bonds and mutual funds. Another popular option is an annuity, an investment product through which an investor, or annuitant, deposits a sum of cash with a guarantor and later receives periodic payments that include the principal amount deposited plus interest. Like any investment vehicle, an equity-indexed annuity has advantages and disadvantages.

Also Known as a Hybrid

Annuities come in different types, and each type has its own set of rules. An equity-indexed annuity is commonly referred to as a hybrid. It combines a fixed annuity with a variable annuity. A fixed annuity provides periodic payments up to a specific date or for the life of the annuitant. A variable annuity's payments are based on the amount of income generated by the investments within its portfolio.

Pros

An equity-indexed annuity allows investors to have the best of the two types described. It comes with a guaranteed minimum rate of return, which is often around 2 percent to 3 percent, according to CNN Money. The annuity is tied to the performance of a benchmark index, such as the Standard and Poor's 500. This means that the investor may still benefit from a rise in the stock market and enjoy a higher rate of return, but the guaranteed minimum rate of return shields the annuitant against major losses due to tumbles in the market.

Cons

Annuities, in general, are complex investment products to understand and often come with many pages of disclosures in an attempt by the guarantor to explain the potential hazards that are inherent within the product. Equity-indexed annuities are no exception, and they can be difficult to comprehend. In addition, depending on how the annuity is structured, you may not receive the full return of the index to which the annuity is tied. Some guarantors place annual caps on returns, exclude dividends or only give you a portion of the return generated. Another pitfall of equity-indexed annuities is the associated fees. Upfront sales fees -- some of which can be difficult for the buyer to see and understand -- are typically very high. And fees charged for abandoning an annuity, called surrender charges, can last for several years and run as high as 20 percent.

Considerations

Due to the volatile nature of an annuity, investors should seek expert guidance before investing in one. Look for a financial adviser or other financial professional who has experience in the annuity market and who can answer all of your questions to your satisfaction. Always take into account any fees charged on the product -- and how those fees could eat into any expected rate of return -- to determine if an equity-indexed annuity investment is one that's worthwhile for your financial situation over the long haul.

About the Author

Mack Mitzsheva is a tax lawyer, personal finance expert and the author of the forthcoming ebook, "10 Best Places to Work Online." Mitzsheva is also a social media entrepreneur with five successful sites under her belt. Always innovative, Mitzsheva is currently developing a cutting-edge budgeting app for newlyweds.

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