Don't be fooled: 'Investment' is insurance

Q: We met with a financial planner because his firm was offering a CD with a great rate. It turns out that his firm actually added two percentage points to the bank-issued CD as a way to entice people to come in and meet with advisers.

The investment suggested to my wife and me sounded great. We placed $100,000 in the investment. It was explained to us that this investment will let us participate in the stock market but provide protection if the market tanks.

The way it was explained to us, if the S&P 500 increases, our investment increases; if the S&P 500 declines, we are guaranteed a 3.25 percent return on our investment. In addition to the guarantee, they gave us a premium bonus of 10 percent of our total initial premium, so we already have $10,000 more in our account than we invested.

We felt pretty good about this investment decision until a few weeks ago, when we pulled out the contract and started reading about specifics. It looks as if the guarantee goes to 1 percent after the first year, and there are things called "cap rates" that we don't understand at all.

I called the adviser and he said we could meet, but because it had been more than 15 days since we received the contract, we won't be able to get out of it.

I asked what would happen if we demanded our money back, and he said we'd lose $20,000 of our initial investment and forfeit the $10,000 premium bonus.

I have attached some of the more relevant pages of our contract for your review. Have we made a huge mistake? If so, when should we take the hit and get out of it?

A: These "investments" are equity indexed annuities, or EIAs. Currently they are not classified as an investment product: They are an insurance product.

EIAs can be complicated. Understanding the features and how they work together is necessary to determine whether this is a good place for your money.

The Securities and Exchange Commission is considering taking over the regulation of these products, which would require more disclosure before the purchase. As an insurance product, you receive the specifics of the contract after the purchase has been made, with the opportunity to examine the contract and return it within a specified number of days for a refund of any premium paid. If you do not return it within the specified time period, it is a binding contract between you and the insurance company.

Planner wins with this setup

Based on the documents you sent me, you are correct that the guarantee is 1 percent after the first contract year. You also have a surrender charge imposed on withdrawals for 16 years from the contract date. If you surrender the contract in the first year, there is a 20 percent charge. This fee decreases by only 0.5 percent each year for the first six years.

It's amazing that you will still have a 10 percent surrender charge after owning this for 12 years. They certainly have you locked in; it must have generated a terrific commission for your "financial planner."

Check with your "planner" about the availability of annual 10 percent surrender-free withdrawals. If allowed, ask what effect, if any, this withdrawal would have on any of the contract specifics, including the initial premium bonus.

If you are over the age of 59 1/2, these withdrawals can be made with minimal tax implications. If you are under age 59 1/2, a 10 percent IRS early withdrawal penalty may apply. This can be avoided by transferring the surrender-free withdrawal to another annuity via a 1035 exchange. Select a no-load annuity or meet with a fee-only financial adviser to assist you with this exchange.

The initial cap rates are only guaranteed for one year, and then they can be reduced. The initial cap rate is 6.25 percent, but it can be reduced to 1 percent. This means that if the selected index value (the S&P 500) increases by 9 percent, your rate will be capped at 6.25 percent the first year and as low as 1 percent the following years.

Some contracts also have participation rates. The participation rate determines how much of the increase in the index will be used to calculate index-linked interest. For example: If the change in the index is 8 percent and your participation rate is 70 percent, the index-linked interest for your annuity will be 5.6 percent (8 percent times 70 percent) unless they reduce the cap rate, and then the interest credited would be equal to the cap rate.

Contracts usually allow the issuing company to set a new cap and participation rates each year. The insurance company issuing your annuity is rated A- by A.M. Best, which is the fourth-highest rating. So you probably won't lose any money, but you probably won't make as much as you could in an alternative and very conservative investment.