What Are Equity-Indexed Annuities?

An equity-indexed annuity is a popular type of annuity, an insurance product commonly used to fund retirement. With equity-indexed annuities, the payout is based on the performance of an equities index, like the S&P 500. Compared to other types of annuities, an equity-indexed annuity is slightly less risky.That’s because it offers greater protection against a market downturn and follows the principles of indexed investing that are popular among conservative investors.

A financial advisor can help you create a financial plan for your investment needs and goals.

How Equity-Indexed Annuities Work

An equity-indexed annuity works just like any other annuity in terms of investing. You’ll pay a set amount of money to an insurance company. That money is then invested into various accounts or securities. Then comes the accumulation period, when the money you invest earns interest or gains value on the market. This is followed by the payout, when you will receive a series of payments for a predetermined length of time. Generally, you’ll start receiving payments once you retire.

Equity-indexed annuities are unique because the money you pay to the insurance company is invested partially based on an equities index. An equities index is a measurement of the overall health of the stock market. It gathers information on the performance of a collection of the biggest companies in a market and tracks how they do. As the market goes up or down overall, so does the index, in turn influencing the yield of the equity-indexed annuity.

Equity-Indexed Annuity Payouts

Equity-indexed annuities guarantee a small return, generally 1% to 3% on most of the premium, with the rest tied to market performance.

Market performance isn’t the only factor that determines returns from an equity-indexed annuity. There is also a guarantee of some payback. Generally, this is a 1% to 3% interest rate on 90% of the premium. The investment in the specified equities index determines the rest.

This guaranteed interest provides downside protection, meaning that you are less likely to lose your principal. The flip side, of course, is that you stand to make less money than if you simply invested in the market and it went up. You are, in essence, trading some potential returns for a more secure investment.

This protection makes equity-indexed annuities a favorite of conservative investors. The payout won’t be as high as it could be with some other investment products. However, there is less risk involved. Thus, you likely aren’t going to see big losses that could seriously impact your retirement plans in a negative way.

Downsides of Equity-Indexed Annuities

As with any investment or savings product, there are risks and downsides that come with using an equity-indexed annuity as part of your retirement savings plan:

Surrender charges. One of the most troublesome fees for equity-indexed annuities is the surrender fee, which is levied when you withdraw principal from an annuity before the predetermined surrender period has ended. For equity-indexed annuities, the surrender period can be as long as 15 years, and the surrender fee can be as high as 20%. This means that when you choose to use an equity-indexed annuity, you’re locking yourself into a situation where you can’t touch your money for a long time unless you pay a pretty hefty fee.
Relatively modest yields. One downside of equity-indexed annuities is that your yield will be relatively modest. If you have other retirement savings, like a 401(k) plan, IRA or pension, that might be okay for you. In that situation, the equity-indexed annuity will simply serve as an extra chunk of change for your retirement, not the sole source of your retirement income.
Limits on investor gains. Most equity-indexed annuities have a participation rate that limits the investor’s gains. Let’s say the participation rate for a particular equity-indexed annuity is 75%. If the index it is linked to shows 10% growth, then investors will only see 7.5% of that profit. This is obviously a lower return than if you simply invested in an index fund. Some equity-indexed annuities also have a cap on the total interest that you can earn.
Potentially high fees. You should also take note of the fees associated with equity-indexed annuities and other investment products. Equity-indexed annuities have sometimes attracted criticism for having high fees. Thus, you should make sure to figure out exactly what you’ll be paying before you purchase an equity-indexed annuity as part of your retirement plan.

Who Should Consider an Equity-Indexed Annuity?

Equity-indexed annuities can be a fit for conservative investors who want some exposure to market-linked growth without fully risking their principal. They are often appealing to people nearing or in retirement who value downside protection but still want the possibility of higher returns than a fixed annuity offers.

These annuities may also work for investors who already have reliable income sources, such as Social Security or pension benefits, and want to add a supplemental income stream that grows modestly over time. In this case, the annuity serves as a buffer rather than the core of a retirement portfolio.

High-net-worth individuals also sometimes use equity-indexed annuities to diversify their income streams and defer taxes. Since earnings grow tax-deferred until withdrawn, these products can be attractive if you expect to be in a lower tax bracket in retirement.

On the other hand, equity-indexed annuities are generally not suited for younger investors seeking long-term growth, or for anyone who may need liquidity. The long surrender periods and fee structures make them restrictive if you need to access your money before retirement.

Here’s a look at how they compare to some other options you may consider:

Equity-Indexed Annuity vs. Alternatives

Feature	Equity-Indexed Annuity	Fixed Annuity	Index Fund
Risk Level	Low to moderate; principal protected but capped returns	Low; guaranteed fixed return	Moderate to high; full market exposure
Potential Returns	Moderate; capped by participation rates and spreads	Low; fixed interest rate	High; tracks market performance directly
Liquidity	Limited; surrender charges up to 10–15 years	Limited; surrender charges apply	High; can sell anytime with no surrender fees
Fees	Often high; surrender charges, rider costs	Low to moderate	Low; expense ratios often under 0.10%
Tax Treatment	Tax-deferred until withdrawal	Tax-deferred until withdrawal	Taxable annually unless held in retirement account
Best For	Conservative retirees seeking market-linked growth with protection	Conservative investors wanting guaranteed income	Growth-oriented investors with a longer time horizon

Bottom Line

An equity-indexed annuity invests in a market index, offers some guaranteed returns, carries fees and is best used as a supplement to retirement income.

An equity-indexed annuity is an annuity product in which the principal you put in is invested in a stock market index, like the S&P 500. A guaranteed interest rate determines roughly 90% of the returns, while the performance of the index determines the rest. Equity-indexed annuities are generally fairly low risk, but they are not going to offer as potentially big of returns as some other investment products and also can carry high fees. Because of this, you likely won’t want to count on them as a primary source of retirement income.

Investing Tips

A financial advisor can walk you through different types of financial investments for your portfolio. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Whether or not you use an equity-indexed annuity, index-based investments are a good option for investors. This is especially true if you want a cheap alternative to actively managed funds. Consider index funds if this appeals to you.