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Annuities are contracts between purchasers and insurance companies. In most cases, the annuity buyer is purchasing a steady income stream to fund retirement.

Some annuities are fixed. With fixed annuities, the interest rate does not change from the percentage set in the contract at the time of purchase. The funds, therefore, are guaranteed to grow at that rate for the period of time specified.

Indexed annuities carry more risk than fixed annuities, but less risk than variable annuities.

Some annuities are variable. Interest rates on variable annuities change according to the performance of an investment portfolio. These annuities carry both the risk of less growth and the opportunity for more, depending on the underlying investments.

And yet other annuities are indexed. The interest rates for indexed annuities — also known as fixed-index annuities — are tied to an equity index, such as Standard & Poor’s index of 500 stocks. The growth opportunity fluctuates more than that of a fixed annuity, but less than the growth opportunity for a variable annuity.

Interested in Buying an Indexed Annuity?
Learn more about indexed annuities and find out if they're right for you.

How Does an Indexed Annuity Work?

According to FINRA, there are several indexing methods 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.
Indexing methods for annuities image

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 – usually at least 87.5 percent – of your principal back, plus 1 to 3 percent interest. If your index performs consistently well, you have the potential to earn a higher return than traditional fixed annuities.

Index Annuity Yields

How your index rate is calculated will depend on the particular 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.

Indexed Annuities vs. Fixed Indexed Annuities

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.

Initially, indexed annuities were referred to as equity-indexed annuities, or EIAs.
Source: SmartAsset

They offer protection against stock market losses, as well as the potential to profit from the market’s gains. While investors in EIAs could benefit from gains in the stock market, the annuities also guaranteed a minimum rate no matter how poorly the market performed.

Indexed annuities took off after the tech bubble burst in 2000. But when investors began to grow leery of stock-based investments, companies dropped the word “equity” from the name and began referring to them as fixed index annuities (FIAs) and just index annuities.

Financial expert Juliette Fairley talks about the popularity of indexed annuities.

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.

  • 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.
  • May provide better rates than certificates of deposit.
  • The gains of your contract will be capped and won’t reflect the entire increase in the value of stocks.
  • High fees and expenses can reduce your gains
  • 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.

Indexed and Fixed Annuity Differences

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.

With an indexed annuity, the amount of the payments to the annuity holder may increase if a predetermined stock index performs well.

The increase will be capped at a certain level, however, and may not account for a raging market.

Even below the yield or rate cap, the increase also may reflect only a percentage of the rise in stock values in the index. This percentage is known as the participation rate. So if your participation rate is 75 percent, your annuity payment will increase by 75 percent of the increased value of the specified stock index, up to the amount of your cap.

If the stock index tanks, on the other hand, your payments will not fall below a preordained level.

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More Questions About Indexed Annuities

How does an indexed annuity respond to the stock market?
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.
What are the advantages and disadvantages of an indexed annuity?
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.
How does an indexed annuity add balance to a retirement portfolio?
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.
Are indexed annuities safe?
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.
What is an annuity rider?
An annuity rider is a contract provision that can be purchased with an indexed annuity to mitigate undesired outcomes and enhance specific benefits.
Please seek the advice of a qualified professional before making financial decisions.
Last Modified: April 6, 2021

13 Cited Research Articles

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