What could be more limitless than an uncapped indexed annuity?

The name of this relatively new twist on annuities makes it sound like the sky is the limit. You get growth and a guarantee, too. Right?

Not so fast, says Jim Poolman, executive director of the Indexed Annuity Leadership Council, an industry group that provides consumer information about indexed annuities of all stripes.

“Uncapped does not mean unlimited. The product manages volatility and is still a safe money investment. But don’t bank on tying yourself to the total gain of a specific index,” Poolman says.

The idea behind indexed annuities is to enable annuity owners to get in on the upside of bull markets. After all, why should insurance companies (which underwrite annuities) rake in bloated gains from a strong market without sharing some of the wealth with annuity owners, whose money the companies are investing?

Indexed annuities tie investment return to market indices, but the annuity itself is not necessarily participating in that index.

This design can potentially boost the returns of annuity owners beyond the relatively low income of traditional annuities. However, all annuities include a minimum guarantee, determined by the specifics of each annuity. This ensures holders of annuities won’t lose money, even when equity markets turn sour.

A plain indexed annuity offers a range of return that fluctuates according to the performance of the index it uses as a market benchmark. Traditionally, an indexed annuity sets a top limit on the return it delivers to holders.

But uncapped indexed annuities remove that ceiling – within limits, Poolman says. The misconception that accompanies the term “uncapped” is that an annuity holder will reap market gains in lockstep with the market index. In other words, if the Standard & Poor’s 500 index rises 10 percent, the value of the uncapped indexed annuity also rises 10 percent.

That doesn’t happen, Poolman and other annuity experts say. Fees and additional costs trim the actual growth of the annuity, Poolman explains. “You cannot compare a straight S&P 500 to an index that a company is using because they are managing volatility. If the S&P gains 25 percent, you’re not going to see a 25 percent gain in the annuity,” Poolman says.

The trick is to understand the potential value of this type of annuity without being mesmerized by the unlikely occurrence of runaway gains. Here’s a way to put a rational cap on your expectations: Try thinking of the “uncapped indexed” element as a different way of calculating the interest earned by the annuity based on an index, says Ron Grensteiner, president of American Equity Investment Life Insurance Co., based in West Des Moines, Iowa, and a chartered financial consultant.

“They say it’s uncapped because they don’t have a stated cap, but the return is a proportion of the change of the index. It’s the change minus the fees,” Grensteiner says.

When fixed indexed annuities were first introduced, Grensteiner explains, they were based on monthly averages of well-known indices, typically the S&P 500 index. Money managers would examine the S&P 500 performance compared with a year before and reset the benchmark as the fund evolved.

That worked when the market was soft. But as the stock market hits higher peaks, the insurance industry has had to keep annuities relevant. Hence, uncapped indexed annuities were born.

At the same time, insurance companies have to control their own risk and cover their costs, so “uncapped” indexed annuities have a “volatility control” or “governor” that moderates the market impact, Grensteiner explains. “Technically, there’s no stated cap, but the construction of the index itself builds in a cap,” he says.

Think of it as “another option for volatility control,” Grensteiner says. The uncapped indexed annuity will grow in sync with the market, but within a narrower range. “Your expectation should be that the return will be 3 percent to 5 percent, not 10 percent to 11 percent,” Grensteiner says.

If the moderate upside and protected downside of an uncapped indexed annuity appeals to you, consider these factors:

1. Uncapped or not, an annuity is still an annuity. Annuities are guaranteed income, and any short-term returns you give up are outweighed by the long-term assurance that the annuity will provide reliable income month after month, Poolman points out.

You may already have annuities with a certain company, but don’t assume you’ll be able to swap into an uncapped indexed annuity to make hay while the market shines. You’ll have to pay fees and penalties to make a switch.

2. Bear in mind that all annuities lock in your principal. Larry Luxenberg, partner with Lexington Avenue Capital Management LLC, a New York financial advisory firm, often reminds new clients that they must offset annuities with investment vehicles they can tap for immediate cash. That strategy doesn’t change simply because an annuity is delivering higher-than-expected returns.

“Look at the other fixed income you have in the mix, including Social Security and pensions,” Luxenberg recommends. “The more fixed income you have already, the less you need to build fixed income into your portfolio.”

Craving simplicity and reliability, near-retirees often move 25 percent to 50 percent of their assets into annuities, Luxenberg has found. “That’s too much because annuities are illiquid,” he says. Typically, he recommends that no more than 20 percent of their principal be locked into annuities.

3. Annuities are safe, but that safety comes at a price. “Your risk is how much you are paying for that guarantee,” Luxenberg says. “Annuities usually have a higher cost than an exchange-traded fund or mutual fund. If you need the principal, it’s not available without huge penalties.”