The Pros and Cons of Indexed Annuities

Annuities are a popular option for people planning for retirement, but there are many different types of annuities that you can choose from. One popular option is an indexed annuity, a hybrid type of annuity that tracks a stock market index, such as the S&P 500 or the Dow Jones Industrial Average. Indexed annuities have some real upsides, but they are not without risk. Like any financial product, there are pros and cons to consider before buying an indexed annuity.

For help figuring out how an indexed annuity might fit into your retirement plan, consider working with a financial advisor.

What Is an Indexed Annuity?

An indexed annuity is a hybrid annuity type. In other words, it takes features from both fixed and variable annuities, with some extra added protections.

With variable annuities, your payout is determined based on the performance of the investments made with the money you pay into the annuity. This is different from a fixed annuity, where the payout is predetermined by rates set by the annuity provider. A variable annuity has the potential for higher payouts when the annuity period arrives, but there’s also higher risk, as poor performance could result in lower payments than you’re expecting. On the other hand, fixed annuities often have minimum rates, typically ranging from 1% to 3% a year.

An indexed annuity works similarly to a variable annuity in that you choose investments that track one of several market indices. A market index is a grouping of companies designed to show the overall performance of the market, or a segment of it. Some of the more well-known indices are the S&P 500 and the Dow Jones Industrial Average. There are also indices that track specific segments of the market, such as tech, healthcare or energy.

But where indexed annuities intersect with fixed annuities is when you consider the alternate return potential within them. Most annuity providers provide a “fixed account” alongside the indices that you can also put your money in. These accounts work just like fixed annuities, offering fixed rates and minimums.

There are many other indexed products available for investing, such as indexed mutual funds and indexed exchange traded funds (ETFs). Indexed annuities take these same principles and apply them to annuities, which provide a consistent income stream for life, making them favored products for retirement planners.

Pros of Indexed Annuities

There are many pros to using an indexed annuity as part of our retirement plan. First, there are the pros that come with any annuity: You get a consistent stream of income in your later years, which is helpful for retirement planning. A study has shown that using annuitized products often helps retirees feel more comfortable spending their money, as the psychological benefit of seeing money come into their account each month makes spending seem more permissible.

Indexed annuities in particular also have some advantages over other types of annuities. For instance, you might be interested in a variable annuity because it has the potential for greater growth than the set income that a fixed annuity provides. With an indexed annuity, you still get that, but with a layer of security provided by the index. Further, indexed annuities follow the market, so there is a better chance of seeing steady gains than in variable annuities where investments are chosen by a manager, which has greater potential for failure.

Indexed annuities also generally have higher rates of return than certificates of deposit (CDs), which are another popular retirement planning product.

Cons of Indexed Annuities

An investor reviewing investment performance on a tablet.

There are some things to look out for with indexed annuities, though. For one, indexed annuities are highly diversified due to their following of an index. While this helps mitigate risk, it also means that the potential for any really large gains is muted.

Indexed annuities also often carry high sales commissions. This is something to consider when purchasing any product. Make sure you do your homework and know exactly what annuity fees and charges you’re paying and what you’re getting in exchange before committing to an indexed annuity, or any other product for that matter.

It’s also worth noting that some indexed annuities have an interest rate cap, meaning you don’t get the full value of your gain. Again, just make sure you know the terms of your annuity contract before you decide to make it a part of your plan.

How Indexed Annuities Can Fit Into a Retirement Strategy

An indexed annuity can serve as a middle ground between market growth and income security in retirement. For many retirees, it can act as a bridge between high-risk investments and lower yield fixed-income options. The market-linked component gives you a chance to benefit from moderate gains during periods of market growth, while the built-in protections help preserve principal during downturns.

These annuities can also play a role in balancing income sources. For example, retirees who already receive predictable income from Social Security or pensions may use an indexed annuity to add potential upside. Meanwhile, those without guaranteed income sources may prefer indexed annuities for their combination of stability and growth potential.

However, it’s important to evaluate an indexed annuity in the context of your broader retirement plan. Factors such as your age, risk tolerance, liquidity needs and other retirement assets should guide how much of your portfolio is allocated to annuities. Because returns are capped, retirees who can tolerate more market risk may prefer to limit their exposure to indexed annuities and keep some assets in diversified investments for higher growth potential.

An indexed annuity should complement, not replace, other retirement savings vehicles, such as IRAs, 401(k)s or taxable accounts. Consulting with a financial advisor before purchasing one can help clarify how an annuity would fit into your long-term income plan and whether its terms match your financial goals.

Bottom Line

A couple meeting with their financial advisor.

Indexed annuities are an insurance product that can be a productive part of a retirement plan. Thanks to their “fixed” component, they can provide a reliable stream of income. Additionally, they can provide returns based on the performance of the underlying investments. But unlike variable annuities, indexed annuities track a stock market index, so the performance of the market as a whole (or a market sector) is reflected in the annuity. Before making it part of your retirement strategy, though, it’s important to weigh both the pros and cons of indexed annuities, and you may also speak to a financial advisor.

Retirement Planning Tips

A financial advisor can help answer questions about indexed annuities and retirement. SmartAsset’s free tool matches you with vetted 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.
Life insurance is another important product to consider, especially if you have minor children. To see how much life insurance you should buy, use SmartAsset’s life insurance calculator.