What Is an Indexed Annuity?

Indexed annuities, also called fixed indexed annuities, are insurance products meant for people who want protection from market volatility but still want some growth. They are often promoted as having no downside and only upside, but that isn’t always the case. These products are described as combining the safety of fixed annuities with the growth potential of variable annuities. Understanding how they work and how they differ from other annuities can help you decide if they fit your retirement plan. Talking with a financial advisor can help you evaluate whether an indexed annuity matches your goals and risk tolerance.

Indexed Annuity Defined

An indexed annuity—also known as an equity-indexed annuity (EIA) or fixed-indexed annuity—is a long-term retirement product that combines features of both fixed and variable annuities.

It’s similar to fixed annuities in that it has a minimum return guarantee, though that doesn’t always mean it’s impossible to lose money. For many indexed annuities, the minimum return guaranteed is at least 87.5% of the principal, plus 1% to 3% interest.

Meanwhile, indexed annuities are like variable annuities in that return rates follow the performance of the stock market. In the case of indexed annuities, insurance companies use a market index like the S&P 500 to calculate an annuity’s interest rate.

Essentially, indexed annuities have the guaranteed floor of a fixed annuity and the potentially higher ceiling of a variable annuity. The rate at which interest compounds can vary from annuity to annuity.

When purchasing an indexed annuity, you can choose an immediate or a deferred option. An immediate annuity, as its name suggests, begins making payments immediately after purchase. A deferred annuity, on the other hand, grows undisturbed for a specified period of time.

Note that unlike most investment products, indexed annuities are not regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Instead, state insurance departments regulate them.

Indexed Annuity vs. Variable Annuity

Indexed annuities track a market index, while variable annuities earn returns from chosen sub-accounts of stocks, bonds, or funds.

As noted, the indexed annuity shares features with the riskier variable annuity. Both can bring higher returns based on the performance of the stock market. With a variable annuity, the interest rate relates to the sub-accounts you invest in, which are often a dozen or more stocks, bonds and money market funds. The interest rate of an indexed annuity, on the other hand, follows a market index.

The starkest difference between an indexed annuity vs. a variable annuity is in what you get back. Indexed annuities come with a minimum return rate guarantee; variable annuities do not.

Because of this, indexed annuities are often marketed as a safer alternative to variable annuities. This is true to an extent, as your lowest possible return with an indexed annuity is higher than that of a variable annuity. However, there is no such thing as a risk-free investment, and the indexed annuity is no exception.

Costs and Surrender Charges of Indexed Annuities

Indexed annuities are not free products. While they may not have upfront fees like some investments do, their costs are built into how the contract works. Caps, participation rates and spreads all act as limits that reduce how much of the market’s growth you actually receive. These features are one way insurers cover the cost of providing guarantees.

Another potential cost of indexed annuities comes from surrender charges. Most indexed annuities require you to keep your money in the contract for a set number of years, known as the surrender period. Taking out more than the allowed amount during this time will result in a penalty. These charges usually start high and then gradually decline over time.

Some annuities also offer optional riders, such as guaranteed lifetime income or enhanced death benefits. While these features can add value, they come with additional annual fees that reduce the overall return.

Should You Buy an Indexed Annuity?

If you’re looking for something more aggressive than a fixed annuity but like the idea of a minimum guarantee, then the indexed annuity could be a good product to consider. But the hybrid annuity is much more complex than its fixed or variable counterparts. Its return may also be more limited than you realize.

For example, if the index increases by 10%, it’s unlikely that you will see a 10% return from your indexed annuity. That’s because, for starters, your interest rate will likely have a cap. So even with a 10% increase in the index, your return may never rise past, say, 4%.

Additionally, many indexed annuities apply a participation rate in conjunction with a cap. This means your final interest rate is a set percentage of an index’s rise. So if the index rises by 10% and you have a 60% participation rate, you would get a 6% interest rate, provided it doesn’t exceed your rate cap.

Or, your interest rate could have a spread fee. This would mean you’d receive the index rate minus the spread fee. So if the index gained 10% and your spread fee was 5%, you would be credited 5%.

These caps and participation rates are usually subject to change throughout the course of your annuity unless spelled out otherwise in your contract. In other words, you could purchase the annuity with a 6% cap, and it could decrease to 4% in five years. Many participation rates will gradually decrease over time.

These conditions don’t necessarily mean that you should avoid indexed annuities. Rather, it underscores how important it is that you are completely aware of the details of the contract before signing anything.

Bottom Line

An indexed annuity offers growth potential with a minimum guarantee, but returns are limited by caps, participation rates and fees.

An indexed annuity is a hybrid product that combines a minimum guarantee with returns tied to a market index. It can appeal to investors who want some growth potential with a level of protection. However, returns are often limited by caps, participation rates and fees. Anyone considering this option should carefully review the contract details to understand both the benefits and the limits.

Retirement Planning Tips

It can be overwhelming to plan your retirement all by yourself. Consulting a financial advisor who’s well-versed in the options can save you time and stress. Finding a financial advisor doesn’t have to be hard. 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.
The first step in any retirement plan is determining how much you need to save. SmartAsset’s retirement calculator can help you calculate the amount of money you need to maintain your lifestyle after you retire.
Make sure to check if your employer offers a retirement plan like a 401(k) or a 403(b), as those can often include contributions from your employer. Never leave free money on the table if you can help it.