Imagine, if you well, that you’ve never stepped inside a donut shop. You might be surprised to see other baked goods, like donut variations, bagels, or cookies, in addition to the varieties of donuts on display. The same is true when it comes to annuities.
While fixed and variable annuities might be considered the glazed donuts and fritters or annuities, there are also indexed annuities. You might think of these as a Long John, donut hole, or cronut.
At its core, it’s still an insurance product that promises you payments, either immediately or in the future. You can also purchase the premium with one payment through a series of payments. However, deviates slightly from how the rate of return is based on.
What is an Indexed Annuity?
Also known as “equity-indexed annuities” or “fixed-indexed annuities,” indexed annuities are complex financial instruments that share some characteristics of fixed and variable annuities. What makes this variety unique is that it offers a minimum guaranteed interest rate plus an interest rate that’s linked to a market index. And, as you’ve most likely connected the dots, hence the name.
Most annuities are based on broad, well-known indices. The most popular is the Standard & Poor’s index of 500 stocks. However, some annuity contracts rely on other indexes, such as the Nasdaq 100, the Russell 2000, and the Euro Stoxx 50.
It’s also possible that certain indices will represent specific segments of the market, while others allow investors to select multiple indexes. And, due to the guaranteed interest rate, you’ll assume greater risk, but less growth opportunity than a fixed annuity. But, they’re not as risky or as high a potential return then a variable annuity.
How Does an Indexed Annuity Work?
As an indexed annuity owner, or annuitant if you want to be exact, you have the opportunity to earn higher yields than other annuity varieties. Of course, the only way that an indexed annuity bests a fixed annuity is when the financial markets are performing particularly well. they also provide some protection against market declines.
Indexed annuities also provide some level of protection against market declines. As such, they’re not as risky as variable annuities. So, in a way, indexed annuities combine the best features of fixed and variable annuities.
Just as with other annuities, you can fund an indexed annuity all at once with a lump sum or with steady payments over time. You also can decide when you want to begin making withdrawals.
You then select an index, like the S&P 500. The annuity company will invest your money into that index. Just know that you don’t have to put all of your eggs into one basket. You do have the choice to split your money across several different indexes.
Here’s probably what you’re most concerned about. And, that’s how the rate on an indexed annuity is calculated. Typically, it’s based on the year-over-year gain in the index that you’ve selected. However, it may also be based on its average monthly gain spanning a 12-month period.
In short, indexed annuities are linked to how a specific index performs. But, there is a caveat. You may not always receive the full benefits of index rises.
Indexed annuities may set limits on the potential gain at a certain percentage. These are commonly referred to as the “participation rate.” Your account will be credited with all of the gains if the participation rate is 100%. But, it could be as low as 25%. FYI, a majority of indexed annuities will offer a participation rate that lands somewhere between 80% and 90%.
So, let’s say that a stock index gained 15% and it has an 80% participation rate. That results in a credited yield of 12%. Not too shabby, right? Just be aware that it’s not uncommon for indexed annuities to contain a high participation rate for the first year or two. After the first couple of years, however, the rate may adjust downward.
Additionally, indexed annuities enjoy a tax-deferred status. Just like with a 401(k) or IRA, all of your investment returns will grow tax-deferred until you begin making withdrawals.
Index Annuity Returns
“One element of indexed annuities that is often misunderstood is the calculation of the investment return credited to your account,” notes Fidelity Viewpoints. “To determine how the insurance company calculates the return, it is important to understand how the index is tracked, as well as how much of the index return is credited to you.”
According to FINRA, there are actually several indexing methods that can determine the change in the index over the lifespan of your annuity:
- Annual Reset (Rachet). This compares the change in the index from the start to the end of the year. Also, declines are disregarded.
- High Water Mark. Uses the index value at miscellaneous points. It then takes the highest of the values and compares it to the level at the beginning of the contract.
- Point to Point. This compares the change in the index rates at two preselected points in time, such as the start and end of your contract term.
- Index Averaging. There are some index annuities that average the value of the index either daily or monthly instead of the value on a particular date.
In other words, the amount that your annuity earns is based on the underlying index. So, if you purchased an S&P 500 index annuity, and it goes up, you just made some money. But, if drops, then you’ll lose money. And, the index is tracked over the periods of time listed above.
Again, there are limits to how much you can gain or lose.
Indexed annuity limits are often set using a combination of the following factors:
- Minimum guaranteed return. Hopefully, your annuity will guarantee an annual baseline minimum return each year. The reason? It ensures that you don’t lose your shirt if the underlying index loses too much money. As an example, you could get paid 1% even if your target index had a negative return for the year.
- Loss floor. Also included in your contract is something called a loss floor. This is the most amount of money that you could lose in the event of a market downturn. For instance, your contract might state that your loss floor is at 10%. As such, your deposit can not drop below 10% from market losses.
- Adjusted value. It’s also possible that your index annuity will lock in your gains systemically. That means if your balance were to go up, your annuity company guarantees that it would not fall below that new adjusted value. And, since it’s locked in, it will stay in place regardless if the index loses money sometime down the road.
- Return caps. However, your annuity company could also set a maximum possible return each year. So, as an example, if the underlying index has earned more money, a return cap means you can not earn more then be 6% each war.
- Participation rate. This is nothing more than the percentage of index returns that the annuity will pay. If your participation rate was a solid 80%, then you would receive 80% of the index gains. As such, if the index rose 10%, you’d receive 8% (10% x 80%). Again, this often tends to be higher in the first couple of years of the contract.
- Spread/margin/asset fees. Additionally, your annuity company could deduct a fee from your index return. If this fee were 5% and the index returned 10%, your gain would be 5% (10% minus 5%).
“One challenge here is that insurance companies typically have the flexibility to lower the participation rate, increase the spread, or lower the cap, which lowers your potential returns,” says Tom Ewanich, a vice president and actuary at Fidelity Investments Life Insurance Company. “If this happens during the surrender charge period after you’ve invested in the annuity, you have very little recourse.”
Additionally, “an often-overlooked point is that for the purposes of the insurance company calculation, an index return excludes dividends, so your return from an indexed annuity will also exclude dividend income,” adds Fidelity. “This is important because history indicates that dividends have been a strong component of equity returns over the course of time.”
“For example, over the past 20 years, ending October 2020, the S&P 500 index has gained 4.26% annually without dividends and 6.30% with dividends,” they add. “Insurance companies are leaving 47% of the return on the table, and that’s before considering any caps, participation rates, and spreads.
And, in case you’re curious, “dividends have made up approximately 40% of the S&P 500’s average annual total return” since 1930.
Index Annuity Withdrawals
As with most annuities, an index annuity grows your saving over time. This can either be for a specific timeframe, like maybe 20 years, or it can be guaranteed for your entire life. Regardless of when you decide to receive payments, investment gains will be taxed at this time. It’s actually the norm with tax-advantaged retirement accounts.
Just like its fixed and variable cousins, index annuity payments are classified as either immediate or deferred.
An immediate annuity will begin payments within 12 months of signing your contract. On the flip side, distributions from a deferred annuity don’t occur until at least a year after signing the contract. As a refresher, the longer that you don’t touch the money, the more robust your index annuity will become. And, that means if you have more in your balance the higher your future payments you’ll be.
What about early withdrawals?
There’s a lot of uncertainty in life. With that in mind, there may be a time with must make an unexpected withdrawal. In this event, you can access your money earlier. The catch? It may cost you.
Your fixed annuity may have a surrender charge based on the guaranteed period of the policy or cancellation of the policy. Some contracts could even impose a market value adjustment if you take money out during one or more of the guaranteed periods offered under the policy. However, in most cases, withdrawals are free as long as it doesn’t exceed 10% of your account value.
How long does a surrender period last? Typically, it’s between five to seven years. The reason being is that index annuities are considered long-term investments, so this discourages you from making touching your money early.
And, like with all annuities, if you make a withdrawal before age 59 ½, you can expect a 10% penalty from the IRS.
Index Annuity Costs
The good news? There usually isn’t an up-front sales charge with a fixed index annuity. But, that doesn’t mean that your annuity is cost-free.
Surrender charges, for example, can be significant. So, if your contract states that your surrender period is five years, and you make a withdrawal in three, you may be charged a fee. Usually, this is around 7% of your balance. This might drop a percentage point annually until it’s gone.
“Also, indexed annuities have significant opportunity costs that are passed on to customers by the insurance company, by limiting potential returns through a participation rate, cap, or spread,” says Tim Gannon, a vice president of product management at Fidelity Investments Life Insurance Company. “That’s why it is important to ask your agent to explicitly define how the product works, so you will know upfront about any factors that could put a drag on your potential return.”
Some of these indexed annuity costs that you should know about include;
- Return limits. It doesn’t matter if the annuity company uses a return cap, a participation rate, a spread/margin/asset fees, or a combination of there. The company will still be holding a portion of the index investment return.
- Mortality and expense fees (M&E fees). This isn’t exclusive to indexed annuities as most will charge M&E fees. This is to cover any future income that’s guaranteed. These fees may also cover the agent’s commission on the sale of the contract.
- Administrative expenses. It’s not uncommon for you to be charged an administration fee for managing the annuity’s contract.
- Rider fees. Riders are additional benefits that you can tack onto an annuity. Of course, you’ll have to purchase these. For instance, you could buy a rider that will guarantee a minimum level of monthly income — even if the index investment tanks.
The Advantages of Indexed Annuities
You may be skeptical of an indexed annuity after learning more about its returns, withdrawals, and costs. But, despite this complexity, they do present plenty of upsides, such as the following perks.
- Moderate return potential. You’ll most likely have a better long-term return with a fixed annuity than what you’d through a bank certificate of deposit (CD), fixed annuities, and savings accounts since your money is being invested in stock market indexes.
- Tax-advantaged growth. As with all annuity types, indexed annuities are tax-deferred.
- Protection against market losses. Overall, this is a safe investment as you’re protected against losses. In short, if the stock market underperforms, you aren’t going to lose the money in your savings.
- Potential preservation of market gains. If your contract permits you to periodically lock in your gains, often this is once a year, you won’t lose sleep over market downturns.
- Inflation protection. Historically, the long-term return of the stock market outpaces inflation.
The Disadvantage of Indexed Annuities
For every Yin, there’s a Yang. That’s just how life works. As such, here are some of the problems with indexed annuities.
- Cap on gains. Unlike if you invested directly in the market, index annuities have a limit on gains. This is because your annuity company puts a cap on potential gains.
- Complicated contract language and regulations. Between caps and participation rates, trying to figure out your return can get complicated. That’s not the case with fixed annuities that are easy and predictable to figure out.
- High fees and expenses. As previously mentioned, index annuities carry a number of fees. If you’re not careful, these can cost you more than if you just invested through index funds on your own — usually via a retirement plan or a brokerage account. Moreover, indexed annuities also have high sales commissions. And, most of these fees and expenses are not clearly disclosed.
- Unpredictable return. Because your index annuity return relies on how the index performs, that creates uncertainty. And, it also doesn’t bod well for you If there’s a terrible market stretch. If so, you might not earn as much as you would if you invested in an account that pays a guaranteed annual return.
Indexed Annuities vs. Fixed Annuities
As discussed several times throughout this guide, annuities have been around for a very long time. That’s not true with indexed annuities. This type of annuity is the new kid in town as it’s only been around since the mid-1990s.
Initially, indexed annuities were created during the stock boom of this era. At the time, investors were more focused on the potentially higher gains of stocks. That meant, that stable and lower returns from investments, such as bonds, were out of fashion. Additionally, indexed annuities were meant to go toe-to-toe with CDs.
The most appealing aspect of indexed annuities is that they can protect your money against stock market losses. As an added perk, they can profit from the market’s gains. At the same time, indexed annuities also offer a guaranteed minimum rate regardless of how the market performs.
Indexed annuities became more popular following the tech bubble burst in 2000. However, when stock-based investments fell out of favor with investors, the word “equity” was dropped like a hot potato from the name. And, that’s why we just call them index annuities today.
So, what’s the main key difference between the newer indexed annuity and traditional fixed annuity? With a fixed annuity, you know how much money is coming your way when you sign the contract. And, that’s not going to change.
An indexed annuity borrows a little from that. While index annuities are based on indices, your payments will never go below a preordained level.
Overall, if you want to grow your money by a definite amount and want to avoid risk, a fixed annuity is the better option. If you don’t mind a little unpredictability in exchange for more growth, then you should consider an indexed annuity.
Indexed Annuities vs. Variable Annuities
With both an index and variable annuity your money will be placed in stock market funds and indexes. What separates the two is that a variable annuity doesn’t come with as many strings attached. Primarily that’s because there aren’t as many limits on gains and losses that an index annuity possesses. While this could give you potentially higher gains, you may also experience also higher losses.
If you’re in for the long haul and can ride out market swings, then you might want to consider a variable annuity as you could earn more money. If you aren’t feeling that level of risk, then an indexed annuity still provides market exposure without the major losses.
More Questions about Indexed Annuities
If you’re still confused about indexed annuities, we’ll wrap this section up by answering your most pressing questions.
How does an indexed annuity respond to the stock market?
Indexed annuities are not securities. As such, they don’t earn interest based on any specific investments. Instead, indexed annuity rates will fluctuate. This will be in relation to a specific index, most notably the S&P 500. And, unlike variable annuities, indexed annuities are guaranteed not to lose money — even if the market tanks.
How does an indexed annuity add balance to a retirement portfolio?
Ideally, your retirement portfolio should be balanced and diverse. To accomplish that, it needs to contain a variety of assets — of which contain varying degrees of risk. Since indexed annuities can be considered balanced, thank to containing features of fixed and variable annuities, these products should be included within your portfolio.
Are indexed annuities safe?
It’s true that indexed annuities are not a safe bet when compared to fixed annuities. However, they are definitely safer than variable annuities. Again, no matter how the market performs, the guaranteed minimum return ensures that the value of an indexed annuity will never dip below the amount that’s been spelled out in the contract.
Are indexed annuities regulated?
As with all annuities, indexed annuities are regulated by state law. If you have questions or concerns regarding a particular product, get in touch with your state insurance commissioner. You can also check out to see if the person selling you an indexed annuity is registered with FINRA by visiting FINRA BrokerCheck or calling (800) 289-9999.
Is an indexed annuity right for you?
That really depends. If you want to potentially grow your money without risking losing your premium, while also enjoying tax-deferred growth, then why not? After all, an indexed annuity is essentially having the best of both worlds.
- What Is an Annuity?
- The Difference Immediate Annuities and Deferred Annuities
- How does an annuity work?
- The Benefits of a Deferred Annuity
- The Benefits of an Immediate Payment Annuity
- What Is a Variable Annuity?
- What Is a Fixed Index Annuity?
- What Is an Indexed Annuity?
- A Brief History of Annuities
- Will Annuities Recover?
- Money for Today or the Rest of Your Life?
- Are There Any Other Types of Annuities?
- Become Familiar With Annuity Fees
- What Are Your Payout Options?
- Weighing the Pros and Cons of Annuities
- Is An Annuity Right For You?
- How To Measure Your Annuity
- Understanding Annuity Formulas
- Annuity Calculators
- Questions To Ask Before Buying An Annuity
- Annuity Glossary Index