Indexed annuities are insurance contracts that provide a stream of income in the future, with investment growth connected to the performance of a stock market index like the S&P 500. Indexed annuities can offer higher potential gains than fixed annuities or certificates of deposit (CDs) in exchange for moderate investment risk.
What is an indexed annuity?
Indexed annuities are insurance contracts that provide regular income payments in the future, and that earn interest based on the performance of a stock market index — for example, the S&P 500 or Nasdaq 100. Indexed annuities can offer different features depending on the insurance company you choose, and these features can limit the growth of your investment, help avoid losses if the reference index underperforms, or guarantee a stream of income for the rest of your life. [1]
Contracts can be complicated, so make sure to check the terms of the specific annuity at hand if you’re considering purchasing one.
How do indexed annuities work?
After you purchase an indexed annuity, you start making premium payments during the accumulation period — the time during which your money will grow and you’ll have potential to earn interest, depending on the performance of the market index specified in your contract. You can typically either make a lump sum payment, or a series of multiple payments, to fund your contract.
After the accumulation period, you’ll enter the payout phase — also called annuitization. This is when you’ll start receiving income payments from your annuity as directed by your contract.
Some annuities don’t have an accumulation and start providing payments right after you purchase your contract — they’re known as immediate annuities. Any contract that has an accumulation period is considered a deferred annuity.
Participation rates
With some indexed annuities, your insurer can set a participation rate, which is how much of the index’s return actually gets credited to your annuity. For instance, if your participation rate is 80% and your selected index grew by 10%, the value of your annuity would grow by 8%.
Floors
Indexed annuities have performance floors, which mitigate your risk as the buyer. Your floor is the maximum amount of money you can lose if the index underperforms. For instance, if your floor against loss is 3%, and your selected index underperforms by 6%, you’ll only lose the 3% that isn't protected by your floor.
Caps
Indexed annuities also come with performance caps, which is the maximum amount of interest you can earn regardless of how well the index performs. Caps help the insurance company protect against risk on their end, in exchange for offering you minimum guarantees via performance floors.
For example, if your cap is 8% and your index grew by 10%, you’ll only get 8% growth credited toward your annuity.
Some indexed annuities have both caps and participation rates, which can further limit the amount of your returns, especially if the market performs exceptionally well.
Surrender period & other fees
The surrender period of your annuity is the amount of time that must pass before you can make withdrawals or cancel your contract without paying penalty fees. Insurers use surrender periods to help ensure they don’t lose money.
The surrender period varies by insurer, but often lasts between three and 10 years. Some surrender periods are gradual, too — you’ll pay steeper fees if you forfeit your policy one year after buying than you would five years after buying.
Many insurers also have administration fees, which can withhold an additional percentage of earnings. For example, if your index return is 8%, and you have an administrative fee of 2%, then your credited return will only be 6%. These types of administrative fees are also called “spread,” “margin,” or “asset” fees. [2]
Indexed annuities can also have steep commissions — which can detract from your earnings as well.
Tax implications
One of the main benefits of annuities in general is tax deferral. You won’t pay taxes on your earnings with an indexed annuity until you start taking withdrawals. You’ll also pay an additional tax if you make withdrawals before age 59 ½. [3]
What are the pros & cons of indexed annuities?
Indexed annuities offer higher potential for returns than fixed annuities, while offering some guarantees in the form of floors. For instance, a floor of 0% “gives the annuity customer a chance for greater return without the risk of losing money,” says Tony Boyden, learning and development partner at Zinnia. However, indexed annuities also come with some risk, since you don’t know exactly how much interest you’ll earn.
Pros
Higher investment potential with some security. Indexed annuities allow you to gain more interest than you would with fixed annuities or certificates of deposit (CDs). Indexed annuities also come with a performance floor, so you'll have a guaranteed minimum return.
Tax-deferral. Similar to other types of annuities, you won’t pay taxes on your earnings until the payout period when you start taking withdrawals.
Protection against inflation. Your earning potential with indexed annuities can help hedge against inflation, as opposed to fixed annuities, where your investment grows at a set rate that doesn’t change.
Cons
Fees and penalties. Indexed annuities can come with steep commissions and administrative fees. Plus, you’ll pay a surrender fee if you withdraw from your policy during the surrender period, which is often between three and 10 years. Exact fees will ultimately depend on the insurer.
Contracts are complex. Not all indexed annuities offer the same benefits, so contracts can be hard to understand without help from an advisor.
Caps and participation rates may limit earnings. Even if the market is performing well, you may be limited by your performance cap.
Types of indexed annuities
Different insurers offer different types of indexed annuities. Each type is linked to the performance of a market index, but the specific parameters and features offered can vary by provider.
What is a fixed indexed annuity (FIA)?
A fixed indexed annuity (FIA) combines features of a fixed annuity with an indexed annuity. The main difference is that it offers a minimum guaranteed return — so you have potential to earn more interest than you would with a fixed annuity — but you won’t lose money. Not all types of indexed annuities will offer you a minimum return.
What is an equity indexed annuity (EIA)?
Equity-indexed annuities (EIAs) are a specific type of indexed annuity. Equity-indexed annuities earn interest based on the performance of a market index, and they usually offer a guaranteed minimum rate of return as well, which isn’t always the case for other types of indexed annuities. [4]
What is a registered index-linked annuity (RILA)?
A registered index-linked annuity (RILA) is another type of indexed annuity, but you take on more investment risk because there’s typically a higher cap and a lower floor. You can choose your own gain and loss limits, which makes this a highly customizable option. Because you take on higher investment risk, RILAs are also considered securities, so they’re regulated by the SEC as well as FINRA. [5]
Learn more about other types of annuities
What should you consider before buying an indexed annuity?
Indexed annuities have complicated contracts that can vary by insurer depending on their offerings, so be sure to read the terms of your annuity — including the caps, floors, fees, and participation rates — before buying. In general though, you should also be mindful of your age, your income needs, and your risk tolerance.
Your age
Indexed annuities are most often used as longer-term investments, so if you’re very close to retirement and therefore closer to needing a reliable monthly income, this might not be the best choice for you.
Your investment goals
If you want higher growth opportunities than with a fixed annuity but still want some protection from market fluctuations, an indexed annuity may be a good fit. As stated above, indexed annuities are often used for long-term investment goals.
Your risk tolerance
If you have a moderate risk tolerance, indexed annuities might be a great fit. You can predict the maximum amount you’ll gain or lose given the terms of your contract, but you’re still exposed to some market fluctuations.
If your risk tolerance is higher and are looking for an annuity that lets you invest more directly in the market with potentially higher — but not guaranteed — returns, consider a variable annuity instead.
Who should consider an indexed annuity?
When buying any type of indexed annuity, you should consider your financial plan as a whole. You want to ask, "is this product suitable for the client? This includes [factoring in] current investments, income, and assets,” says Boyden.
If you’re comfortable with some uncertainty in regards to your interest rate, you’re aware of any extra fees that come with your contract, and you’re looking for another tax-deferred investment vehicle, an indexed annuity could be right for you.
