Annuities have existed for a very long time, tracing their origin to the lifetime annual stipend or "annua" promised to soldiers loyal to the Roman Empire.
Contemporary versions include the fixed variety based upon a constant interest rate, and the variable annuity, which carries market risk.
However, a relatively new and nefarious innovation has gained increasing attention, particularly among retirees and those approaching retirement.
Known as Equity-Indexed Annuities, or EIAs, these instruments are costly, complex and illiquid financial contracts that should be avoided by most investors.
Often purported to provide "guaranteed retirement income", equity-indexed annuities advertise a minimum threshold return combined with the potential to share in any gains in an underlying market index like the S&P 500 upon which the contract is based. Of course, something that sounds too good to be true usually isn't.
The minimum guaranteed return is typically some percentage of the original investment (87.5 percent is common), invested at a 1 percent to 3 percent annual rate. However, the upside is limited by the contract terms. A stated participation rate restricts the share of the gain (often 70-80 percent of the index), and many contracts contain rate caps that limit the absolute gain. Some EIAs allow the issuer to alter the rate cap or participation rate, and most carry hefty administrative fees.
Dividends earned by the underlying investment are typically not reinvested. Many contracts provide guaranteed death benefits for an additional fee.
Unlike variable annuities which are considered securities and are, therefore, governed by the SEC, equity-linked annuities are not federally regulated but fall under the aegis of state insurance authorities.
Furthermore, the guarantees are only as good as the issuing insurance company. While the failure of a major insurer is rare, it is nonetheless possible. Bear in mind that the company must remain solvent over your entire lifetime.
A common marketing gimmick among purveyors of EIAs is an "up-front bonus" of 5 percent to 10 percent. However, most investors never actually realize the bonus, since the contracts require the investor to wait up to 20 years before canceling the contract without being subject to onerous surrender charges that run as high as 25 percent.
The promise of upside gain with no downside risk sounds compelling, but the reality of EIAs is much different for most investors. To paraphrase William Randolph of colonial Virginia, "like a rotten mackerel in the moonlight, it shines and stinks."
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Chris Hopkins is vice president, investments, at Barnett & Co. Inc. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at firstname.lastname@example.org