What Is a Fixed Indexed Annuity & How Does It Work?

Annuities come in many different forms, and fixed indexed annuities offer the chance to combine the benefits of other annuities. Rather than rely solely on a fixed interest rate or the performance of a market index, this annuity offers both. While the insurance company itself determines fixed rates, annuitants will be able to choose the index they want their assets to follow. However, these dollars don’t actually go into the index, which means you won’t lose any money if the index loses value.

A financial advisor can help answer your questions about whether or not a fixed indexed annuity is a good fit for you.

How Fixed Indexed Annuities Work

A fixed indexed annuity is a long-term savings insurance contract that offers two ways of earning interest, also called crediting strategies. The strategy with the lowest risk and upside is the “fixed” part of the annuity. For this, the insurance company offers a fixed interest rate for a specific number of years, similar to a certificate of deposit (CD). Often the initial rate is for just one year. The rate then resets, usually annually, but it will never go lower than the minimum rate the company guarantees.

The other crediting strategy, which offers more upside, is the “index” part of the annuity. Money in this part of your account will earn interest based on the performance of an index, such as the S&P 500. But these rates generally have restrictions around them, some of which are helpful and some of which aren’t.

For starters, because your money doesn’t actually go into the index fund, insurance companies will usually offer a 0% floor. That means the worst your money can do is not grow at all and stay the same. However, there are also participation rates and rate caps, which can limit how strong your returns can be. Here’s how each works:

Rate cap: If your contract has a 6% rate cap, for instance, that’s the maximum return you can receive. So even if the index garners 9% in returns, the best you’ll do is 6%.
Participation rate: For contracts with a participation rate, you’ll receive a certain percentage of the growth your index experiences. So if your contract has a 50% participation rate and your index grows by 8%, you get 4% in returns.

Once your account is open, you can decide how much you want to allocate to each strategy. Often, there are several index strategy options, so you can allocate your money to more than one. Any money you don’t attribute to an index will grow through your contract’s current fixed rate.

Because annuities are retirement savings products, their withdrawal rules are quite stringent. As a result, insurance companies typically punish you with hefty withdrawal charges if you take money from your account before the contract’s terms stipulate you can. In addition, the IRS will charge you a 10% early withdrawal penalty if you withdraw from your account before you turn 59 ½ .

How to Invest in a Fixed Indexed Annuity

The first thing to do when wanting to invest in a fixed indexed annuity is to buy an annuity contract. You’ll have to transfer funds to the annuity contract and then choose an index to invest in. You can transfer funds in one lump sum directly from your bank, make smaller transfers over a period of time or make a direct transfer from your retirement account.

Many fixed index annuities will have a minimum initial investment amount and a minimum additional investment amount. For example, an annuity may have an initial investment amount of $100,000, with an additional investment amount of $1,000. This means the first time you invest in the annuity you have to put up the $100,000, but you can invest much smaller increments of $1,000 down the road.

Your biggest decision will be how you direct the annuity company to invest your funds. You can choose to invest in a single index or spread out your money over several indexes. This choice will likely depend on what your goals are with the investment. It’s important to study the contract, as a fixed indexed annuity may not behave in the way you’re expecting.

Pros of a Fixed Indexed Annuity

Some of the major benefits of a fixed indexed annuity are:

Protection against market volatility: Perhaps the biggest benefit of a fixed indexed annuity is that it’s protected from the volatility of the market. As we stated above, your money is never actually in the stock market. While your crediting strategy tracks the stock market, you don’t own securities that can fall in value. In turn, you don’t have to worry about losing funds.
Affordable: Fixed indexed annuities are some of the cheapest retirement savings products there are. In fact, they usually don’t have any annual fees whatsoever. With some contracts, you may have the ability to buy benefit riders, which extend your coverage in areas like death benefits and income but will cause you to incur a fee. Even still, compared to variable annuities, fixed indexed contracts are extremely low-cost.
Higher fixed rate: To entice buyers, insurance companies will often offer a high initial fixed interest rate. Sometimes this high rate is “enhanced” or “boosted,” though, so it may only last for a year. The insurance company also guarantees a minimum interest rate. This can be appealing in an environment where interest rates are less than 1%, as most caps are 1%.
Lifetime payout benefits: Additionally, once you turn your nest egg into an income stream, you cannot outlive that income stream. This, of course, assumes you choose the lifetime payout option. This is important, as life expectancies rise and Social Security benefits will likely change. Should you die before you annuitize, the insurance company will pay a death benefit equal to the number of your payments, minus any withdrawals and taxes.
Joint contract option: Fixed indexed annuities can be opened as joint contracts. If you decide to go this route, you or your spouse will take over the contract should either of you pass away. This level of protection can be comforting, as it ensures your money will stay in your family.

Cons of a Fixed Indexed Annuity

Some of the other cons of a fixed index annuity are:

Limited growth potential: A fixed indexed annuity’s trade-off for being low-risk is fairly mediocre growth potential. That’s because even if an index performs exceptionally well, you’ll likely miss out on some of those returns due to rate caps or participation rates. These are unfortunately unavoidable, though you can shop around to find the best terms.
Can be counterintuitive: If you want to avoid restrictions altogether, you’ll need to invest in the funds directly through the market. Of course, if you do that, you’ll miss out on the tax-deferred benefits of an annuity. You’ll also encounter more risk, though index funds are generally reliable.
Risk of slowed asset growth: Fixed indexed annuities may be lower risk than many investments, but they still come with some risk. That’s because while you can’t actually lose money with investments, the potential for 0% returns with a fixed indexed contract will still slow your asset growth. Although losing your cash is undeniably worse, it still hurts your retirement funds.
Can lose buying power: Another potential issue with fixed indexed annuities is that if your returns grow at a slow rate, you run the risk of losing buying power due to inflation. So even if you technically gain, your money may not have kept up with inflation, which means you still lost some value.

Fixed Indexed Annuities vs. Other Types of Annuities

If you’re buying an annuity, it’s important to figure out what type of contract is best for you. Alongside fixed indexed annuities, there are three other main types of annuities: fixed annuities, indexed annuities and variable annuities. Here’s a look at how they compare:

Fixed annuities: Fixed indexed annuities offer a “fixed account” that allows contract holders to take advantage of a predetermined interest rate. A fixed annuity works exactly like this, only it doesn’t come with an indexed account alongside it. While that might make them seem less appealing compared to a fixed indexed annuity, they sometimes offer better fixed rates due to their overall lower growth potential. So if you’re planning on allocating most of your money into your fixed account anyway, a fixed annuity might be a better option.
Indexed annuities: On the other hand, indexed annuities share the indexed feature with fixed indexed annuities, only they’re lacking a fixed account. The main perk an indexed annuity might offer over a fixed indexed annuity is stronger earnings caps and participation rates. This can make it the preferable option for those more focused on indexing their assets.
Variable annuities: Compared to other types of annuities, variable annuities offer the best return potential. That’s because they are completely centered around investing. They allow you to physically invest your money in a fund rather than have your assets index its performance. This feature is also the downfall of the variable annuity, though, as it makes them extremely risky contracts.

How to Choose an Annuity for Your Retirement Needs

Choosing an annuity for retirement starts with understanding your financial goals and income needs. Ask yourself what you want the annuity to accomplish, whether that’s steady monthly income, protection from market losses or long-term growth. If your main goal is predictable cash flow, a fixed or immediate annuity may work best. But if you’re comfortable taking on more risk for higher potential returns, a variable or indexed annuity could be more suitable. Knowing your priorities helps narrow the options before you get into comparing specific products.

Next, think about when you’ll need the income. Some retirees want payments to begin right away, while others prefer to let their money grow for several years before taking distributions. Immediate annuities start paying almost at once, which is useful for covering near-term expenses. Deferred annuities, by contrast, allow funds to accumulate and can provide income later in retirement. Deciding on the right timing ensures your annuity fits naturally into your overall income plan.

Cost is another important factor. Annuities can include a range of fees, such as administrative charges, mortality and expense risk fees or costs for optional riders that add features like inflation protection or death benefits. These annuity charges reduce your overall return, so review each fee carefully before purchasing. A lower cost annuity might provide similar benefits without unnecessary extras.

It’s also important to evaluate the financial strength of the insurance company issuing the annuity. Because annuities are long-term contracts backed by insurers, the company’s ability to meet future obligations is critical. Check ratings from independent agencies like AM Best or Moody’s to make sure the provider is financially stable. A strong insurer offers more confidence that your future payments will be secure.

Finally, consider how the annuity fits into your broader retirement strategy. It should complement, not replace, other income sources like Social Security, pensions or investment withdrawals. Diversifying between guaranteed income and growth-oriented assets helps manage both market risk and longevity risk. Before making a commitment, review the contract terms with a financial professional who can explain how each option aligns with your needs, goals and risk tolerance.

Bottom Line

A couple reviewing fixed index annuities.

Fixed indexed annuities combine the low risk of a fixed annuity with the potential capped returns of a variable annuity. But the tradeoff for less risk is less growth. It should also be noted that these annuities are low-risk, not no risk at all. Additionally, since an insurance company backs your fixed indexed annuity, all guarantees depend on its financial outlook.

Tips for Buying an Annuity

Annuities are complex financial products, so the help of a professional might be worth seeking out. Luckily, finding a financial advisor that can help you with your retirement plans doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors who serve your area. You can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Check the financial outlook of an insurance company before buying an annuity. After all, if you’re counting on receiving payments for life, you should be sure the company will be around. The major financial rating agencies are Standard and Poor’s, Fitch and A.M. Best.