Annuities once came in two basic varieties. On one side were “fixed” annuities that provide the holder with modest returns but the security of guaranteed payments. The alternative was a “variable” type, whose return is based on how well a basket of stocks or bonds performs.

Over the last several years, however, annuity customers have had a third, middle-of-the-road option. Equity-indexed annuities – now more frequently called “indexed annuities” – feature a guaranteed return as well as a market-based return. The result is greater upside than a traditional fixed contract, with less risk than a variable annuity.

If sales figures are an indication, many investors see indexed annuities as a “best of both worlds” proposition. Sales reached a record $39.3 billion in 2013, according to LIMRA Secure Retirement Institute – that’s a 16% gain over 2012.

But before jumping into an indexed annuity, investors should read the fine print. While these products may represent a good fit for certain portfolios, they’re notoriously complex products that can vary significantly in quality.

How they work

As with other annuity contracts, indexed annuities are sold by insurance companies and require the owner to make a one-time payment or series of premium payments. Then, at a predetermined date, the annuity disburses either a lump-sum figure or regularly scheduled payments to the holder.

Exactly how much you receive is one of the aspects of an indexed annuity that can leave you scratching your head. What some customers don’t understand is that the guaranteed portion of interest may not cover the full amount of the premiums paid. In most states the guaranteed minimum return is at least 87.5% of the premium paid, plus 1% to 3% interest. Policies vary by company, so reading the details of the contract is crucial.

The other part of the return is based on the performance of a specific market index, such as the S&P 500. But if the index goes up 15% one year, don’t expect your indexed annuity to pay that amount on top of the guaranteed return. Some companies use what’s called a “participation rate,” which is how much of a market’s gain they’ll pass along to the annuity holder. If the participation rate is 70% and the market goes up 10% in a given year, the index-related return will be 7%.

Other companies put an outright cap on the amount of their market-based return. For example, their maximum payout could be 8%, even if the index they're using performs better than that.

The method for computing market-based returns varies considerably from one insurance carrier to the next, so it’s important to understand the details. But beware – some indexed annuities allow the company to change the amount of the cap even after the annuity is sold.

You Can Lose Money

While indexed annuities are seen as more conservative than variable annuity contracts, they nonetheless carry risks. Because many annuities pay a guaranteed return on only part of the premium – 87.5% or more – it’s actually possible to lose money with such products. One way this could happen is if the stock market goes down and the annuity therefore doesn’t provide an index-based return.

Buyers can also take a haircut on their investment if they try to back out of their policy early. While some insurers have shortened the “surrender period,” most still require the owner to stick with it for 5-10 years if they want to avoid a sizable fee. In addition, surrendering your policy could subject you to a 10% tax penalty from the IRS.

It’s also important to remember that the reliability of annuities depends on the financial strength of the company that issues them. If the insurer is undercapitalized, there’s an outside chance that it won’t be able to make good on its full guarantee. Be sure to look up the financial rating of the firm from agencies like A.M. Best, Standard & Poor’s and Moody’s. Stick with carriers that earn the highest marks.

But the Broker Gets a Fat Commission

The labyrinthine rules that accompany indexed annuities aren’t the only reason they’re controversial. Insurance companies usually pay brokers a hefty commission to sell such products, which, fairly or not, can raise suspicions about why they’re being recommended.

While commissions have actually dropped in recent years, insurers continue to pay an average of more than 5% to professionals who sell such products. As such, it’s in the best interest of people considering an indexed annuity to know what the compensation rate is and to work with an advisor they trust.

The Bottom Line

Indexed annuities are a compelling compromise between fixed and variable annuity products. But before deciding to buy, customers need to understand what they’re getting into and remember that they are products designed for long-term investment. Seeking the help of reliable investment professional can ensure that you make a decision that suits your goals.