Pop quiz: What do you know about index annuities?

It’s meant for consumers, but sadly, far too many advisors will fail. The Wall Street Journal‘s Leslie Scism offers the following quiz on equity (or fixed) indexed annuities. How well did you do?

1) Which is true of an equity-indexed annuity?

1. It returns the higher of a fixed interest rate or an amount tied to a market index, like the Standard & Poor’s 500-stock index.
2. It contains restrictions on how much of the index’s gain you receive.
3. Steep surrender penalties often apply.
4. The product is backed by the Federal Deposit Insurance Corp., which covers bank certificates of deposit.
5. A, B and C
6. All of the above

ANSWER: E.

2) What method is commonly used for computing the index-based interest?

1. A “participation rate” gives you a set percentage–say, 80%–of the index’s gain.
2. A cap sets a maximum level of index-based gain. If the index gains 10% and the cap is 8%, you get 8%.
3. A spread applies: You get, say, three percentage points less than the index return.
4. All of the above, some simultaneously.

ANSWER: D.

3) What method do insurers commonly use to determine the index’s price change?

1. “Annual reset,” comparing the index’s level at the start and end of each contract year.
2. “Point to point,” comparing the index’s level at the start of the contract with the level, say, five years later.
3. “High water mark,” using the index’s highest level on any contract anniversary date during, say, a five-year period.
4. “Index averaging,” in which the index’s value is averaged over a specified period.
5. All of the above, and more.

ANSWER: E.

4) True or false: In most contracts, insurers can reduce participation rates, impose stiffer caps and widen spreads after you buy the annuity.
ANSWER: True.