Key Takeaways
- An indexed annuity provides a rate of return based on the performance of a market index like the S&P 500.
- You can invest your annuity premium into a single market index or across several indices.
- Indexed annuities guarantee a minimum interest rate and you don’t lose money even if the market underperforms.
- The issuing insurance company can cap your gains to protect itself from losses.
An indexed annuity is a financial contract between you and an insurance company. It features characteristics of both fixed and variable annuities.
Indexed annuities offer a minimum guaranteed interest rate combined with an interest rate tied to a broad stock market index, such as the S&P 500 or the Dow Jones Industrial Average.
This unique hybrid design can offer protection against stock market losses, as well as the potential to profit from the market’s gains.
Indexed annuities were created during the stock boom of the mid-1990s when investors were more interested in the potentially higher gains of stocks and less interested in stable, lower returns from investments like bonds. They were specifically designed to compete with certificates of deposit.
How Does an Indexed Annuity Work?
After you sign an indexed annuity contract, the insurance company invests your money into the market index of your choice. You can select a single index for your funds or spread your dollars across several indexes.
The most common index options include the S&P 500, the Nasdaq 100 and the Russell 2000.
In exchange for protection against losses, indexed annuities limit how much you earn, even in strong market years.
That’s why these contracts are considered less risky than investing directly in the stock market but also offer smaller potential gains.
There are several mechanisms insurers use to determine the change in the index over the time you have the annuity:
- Annual Reset (Rachet)
- Compares the change in the index from the start of the year to the end of the year. Declines are ignored.
- High Water Mark
- Looks at the index value at various points and takes the highest of the values and compares it to the level at the start of the contract.
- Point to Point
- Compares the change in the index rates at two preselected points in time. This can be the start and end of the contract term.
- Index Averaging
- Some index annuities average the value of the index daily or monthly, as opposed to the value on a particular date.

Annuities also offer tax advantages. Interest earned within an indexed annuity is tax deferred. You won’t pay state or federal income tax on the interest until you withdraw it.
Index Annuity Yields
How your index rate is calculated will depend on the provisions of your annuity contract.
According to the Financial Industry Regulating Authority (FINRA), the computation may typically involve three factors:
- Participation Rate
- This is the percentage of the gain in the stock index you will receive on your annuity. For example, if the participation rate is 80 percent and the index gained 10 percent, the annuity would be credited with 80 percent of the 10-percent gain, or 8 percent.
- Spread/Margin/Asset Fee
- Some index annuities use this in place of or in addition to a participation rate. This is a percentage that is subtracted from any gain in the index. If the fee is 3 percent and the index gains 10 percent, then the annuity would gain 7 percent.
- Interest Rate Caps
- Some index annuities put an upper limit on your return. So if the index gained 10 percent and your cap was 7 percent, then your gain would be 7 percent.
Guaranteed Minimum Return
Index annuities carry what’s called a guaranteed minimum return. Typically, this means if you buy an index annuity, you are guaranteed to receive at least a certain amount.
For example, if the stock market loses 2 percent of its value next year and your guaranteed minimum rate is 3 percent, you’ll earn 3 percent.
If your index performs consistently well, you have the potential to earn a higher return than traditional fixed annuities.
On the other hand, if the stock index tanks, your payments will not fall below a preordained level. Guaranteed minimums on indexed annuities typically range from 1 to 3 percent per year.
Read More: What Is a Fixed Annuity?
Who Should Get an Indexed Annuity?
Indexed annuities are best suited for investors who don’t need the money right away. According to Annuity.org expert contributor Chip Stapleton, indexed annuities are most beneficial for investors with 10 to 15 years before they’ll need income because they’ll have time to weather any downturns that might reduce the annuity’s return.
Most indexed annuities have some downside protection, said Stapleton, who is a FINRA Series 7 and Series 66 license holder and CFA Level II candidate.
“It might even be a floor of zero, so you’re never going to lose money,” he said. “But then your upside is also capped there too, so if you want to limit your bad, you also have to limit your good.”
The market exposure of indexed annuities is mediated by downside protection, meaning that these products have a moderate amount of risk. Stapleton recommended this type of annuity for “someone who’s more risk averse but doesn’t want to avoid risk completely.”
Stapleton also pointed out that indexed annuities can be customized to fit the annuity owner’s financial circumstances.
“You can design what you’re investing in inside the annuity to tailor your risk profile more based on your goals, your time horizon and your general investment philosophy,” Stapleton said.
The case study below provides an example of how someone about to retire can benefit from the features of an indexed annuity.

Hallie is nearing retirement and is looking for a way to generate guaranteed income to supplement her Social Security checks.
She wants to add some flexibility to the conservative part of her portfolio. She considered purchasing bonds, but she’s worried a large bond investment won’t keep pace with inflation.
An indexed annuity is a good fit for someone like Hallie because these annuities offer a low-risk way to generate predictable income. She’s guaranteed not to lose money, so it’s a lower risk investment than a variable annuity, which would expose her to downturns in the stock market.
Indexed annuities also offer much lower fees than variable annuities with favorable yearly returns.
“With indexed annuities, you usually have less fees,” Stapleton said, “so if you’re fee-conscious but want to go for an annuity, an indexed annuity could be a great option.”
“Conservatively, these products (indexed annuities) are designed to return between 3 and 7 percent net,” said Chris McDonald, director of annuity and institutional sales at Senior Market Sales in Omaha, Nebraska. “However, we’re seeing returns much higher than that on average, often between 6 to 10 percent.”
Some investors choose indexed annuities over investing in index funds directly because of the tax advantages. Since annuities grow tax-deferred, you won’t owe taxes until you withdraw funds, unlike traditional investment vehicles like brokerage accounts.
Another reason one might choose an indexed annuity is the variety of benefits and features annuities provide. Stapleton cited examples like long-term care riders, death benefits and guaranteed income as advantages that make indexed annuities more beneficial for some people.
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Index Annuity Pros and Cons
Like any investment, index annuities have their benefits and costs. Since they are essentially a hybrid of fixed and variable annuities, they have a mixture of pros and cons. They have the potential of higher returns without the risk of losing your money. Because these annuities are complicated, they can be difficult to understand.
Pros & Cons
Pros
- As with all annuity types, indexed annuities are tax-deferred products.
- When stocks in your index, such as the S&P 500, increase in value, the value of your contract increases.
- The added increase in yields may serve as a hedge against inflation.
- If the stock market underperforms, you don’t lose money.
- Index gains are locked in.
- They often provide better rates than certificates of deposit.
Cons
- The gains of your contract will be capped and won’t reflect the entire increase in the value of stocks.
- Lack of fee transparency. Fees may not be clearly disclosed.
- High sales commissions.
- The cap in the increasing value may be reduced in the later years of your contract. In addition, the percentage of the gain you may receive in the index value may decrease.
- As with other types of annuities, you face steep surrender charges for early withdrawal.
- With a fixed annuity, the amounts of the income payments are present in the contract. They do not change, except when the contract calls for them to be reset.
Comparing Indexed Annuities to Fixed and Variable Annuities
Indexed annuities are just one of the three main annuity types. The other two are fixed annuities and variable annuities.
Fixed annuities are not tied to the performance of the stock market. The interest rate is set in your contract at the time of purchase and does not fluctuate. The funds, therefore, are guaranteed to grow at the same rate for a specified time.
With an indexed annuity, the amount of the payments to the annuity holder may increase if a predetermined stock index performs well.
Interest rates on variable annuities change according to the performance of an investment portfolio. However, variable annuities don’t include the same limits on losses as an index annuity. If the investments you choose for your variable annuity decline, then the value of your annuity will also decline.
Variable annuities carry the risk of less growth and the opportunity for more, depending on the underlying investments.
Because the interest rate is tied to market performance, indexed annuities expose you to more risk — and greater potential returns — than a fixed annuity.
On the other hand, the guaranteed minimum return of an indexed annuity makes it less risky than a variable annuity — but with the potential for lower returns.
More Questions About Indexed Annuities
Indexed annuities are not securities and do not earn interest based on specific investments. Rather, indexed annuity rates fluctuate in relation to a specific index, such as the S&P 500. In contrast to variable annuities, indexed annuities are guaranteed not to lose money.
Indexed annuities guarantee that you won’t lose money. If the index is positive, then you are credited a certain amount of interest based on your participation rate. If the market tanks, you’ll receive a fixed rate of return — or no loss of your original principal instead.
The advantages of indexed annuities include the potential to earn more interest and the premium protection they offer. The disadvantages include higher fees and commissions and caps on gains.
A balanced retirement portfolio requires a mix of assets with varying degrees of risk. Because indexed annuities are inherently balanced — having features of both fixed and variable annuities — these products can be included in a portfolio without skewing asset allocation.
Indexed annuities are not as safe as fixed annuities, but they are safer than variable annuities. The guaranteed minimum return ensures that an indexed annuity’s value won’t fall below the amount specified in the contract.
An annuity rider is a contract provision that can be purchased with an indexed annuity to mitigate undesired outcomes and enhance specific benefits.