What Is a Fixed Indexed Annuity?

How Does a Fixed Indexed Annuity Work?

A fixed indexed annuity, also called a fixed index annuity, is a contract with an insurance company that provides guaranteed payments based on the performance of an underlying stock market index, such as the S&P 500 or the NASDAQ 100.

How Rates Are Calculated

Fixed index annuities track a specific stock market index and calculate a rate of return based on its performance. The rate is typically calculated yearly based on the prior year's gain or loss.

Participation Rates, Spreads and Rate Caps

The returns on most fixed index annuities don't reflect the full amount of a gain. Instead, a participation rate may determine the percentage of the gain that's used to set the rate. This is the percentage of the money you've invested that's eligible to earn returns. At an 80% participation rate, a 10% gain in the index translates to 8% (or 80% of 10%).

Alternatively, you may have a spread/margin/asset fee that subtracts a percentage from the actual gain. A 2% spread, then, converts an 8% gain to 6%.

Example: If your participation rate is 80% and your spread/margin/asset fee is 2%, here's what you might expect to net:

Annuities may also have rate caps that limit the total gain you can have in the year, regardless of spreads or participation rates. If your annuity has a 5% rate cap, that's the maximum gain you will see.

Minimum Rate of Return

A fixed indexed annuity also sets a minimum rate of return, which protects you when the index declines. The minimum rate of return is typically low—2% or even 0% are common—but it's primarily meant to prevent you from losing money in a down market. Because of this protection, you don't risk losing your principal, even if the market tanks.

Adjustments to Value

Periodically, the principal value of your annuity may be adjusted to reflect your gains. When this happens, you lock in the gains you've made and increase the principal used to calculate your annual earnings.

Tax-Deferred Growth

Like the gains you may have in a traditional individual retirement account (IRA) or 401(k), earnings in an annuity are tax-deferred. You don't pay taxes on your gains until you withdraw your money. That allows you to keep more of your money invested, so it can continue to grow and compound.

Costly Withdrawals

Because a fixed index annuity is taxed like a retirement account, you may pay an early withdrawal penalty and regular income tax if you withdraw money before age 59½. You may also pay a surrender fee for making a substantial withdrawal or canceling your contract during the annuity's surrender period.

Riders and Special Features

Your annuity may also be customized with optional features or riders. For example, a guaranteed minimum income benefit provides minimum income payments for life, regardless of market performance. Optional death benefits can provide payments to your beneficiaries after you pass.

Learn more: Are Annuities Safe?

Fixed Indexed Annuity vs. Fixed Annuity

A fixed indexed annuity pays interest based on the performance of a stock market index; a fixed annuity pays a fixed rate that isn't affected by market performance. Here's a quick side-by-side comparison of the two types:

Which is better? Long-term investors might be willing to deal with a few market ups and downs in exchange for a higher potential return. A fixed indexed annuity still protects your principal and limits your potential for loss, while allowing you to participate in market growth.

Short-term investors may prefer the predictability of a fixed annuity. With a fixed annuity, you know exactly how much money you'll make, which can simplify planning.

Learn more: Fixed Annuities vs. CDs: What's the Difference?

How Much Do Fixed Indexed Annuity Fees Cost?

Because fixed indexed annuities are relatively complex, they tend to have higher costs. Expenses vary from one fixed indexed annuity to the next, but the following costs and fees are common:

• Commissions: The agent or broker you're working with may be paid a commission on your annuity contract. According to Annuity.org, commissions on fixed index annuities typically range from 6% to 8% of the contract's premium. However, commissions are often built into the cost of the contract, so you may not see one broken out as a separate fee.
• Administrative fees: These cover the basic costs of administering your annuity.
• Mortality expenses: These fees help compensate the insurance company for the risk it assumes by guaranteeing income and covering the terms of your annuity agreement.
• Riders: Riders are optional features that help customize your contract. Common examples of fixed index annuity riders include guaranteed lifetime withdrawal benefits, which allow you to withdraw a percentage of your principal every year for life, and enhanced death benefits, which guarantee minimum benefits for your loved ones when you die. You only pay for the riders you choose.
• Expense ratios: An expense ratio is a fee for managing your annuity's investments. It's similar to fees you might pay on a mutual fund or index fund.
• Rate spreads: If your annuity subtracts a percentage of your index's gain as a spread/margin/asset fee, that spread is part of your annuity costs.
• Surrender fees: If you cancel your contract or withdraw a significant amount of money (say, 10% or more) during the first few years of your annuity, you may be charged a surrender fee, as outlined in your contract.

Pros and Cons of Fixed Indexed Annuities

As retirement investments, fixed index annuities have their unique pros and cons. Here are a few to consider:

Who Should Invest in Fixed Indexed Annuities?

Many people invest in annuities to help balance out their retirement portfolio. Tax advantages, lowered risk and guaranteed income make fixed index annuities an attractive choice, but you may want to think through your motivations on either side of the argument.

When to Invest in Fixed Indexed Annuities

• You want to participate in market gains but with less risk.
• You're willing to accept lower gains to protect your principal.
• You want guaranteed income in retirement, potentially for life.
• You don't need to tap your annuity investment for cash.
• Your annuity is part of a larger retirement financial plan that includes Social Security and pensions, retirement accounts, cash savings and/or investments.

When Not to Invest in Fixed Indexed Annuities

• You want to make the maximum return on your investment in stocks.
• You are willing to risk market losses to get higher gains.
• You would prefer even more predictable results, as with a fixed annuity or certificate of deposit (CD).
• You want to use your money for emergencies or spending.
• You aren't sure how an annuity fits into your larger retirement financial plans.

Learn more: Types of Annuities to Know

How to Invest in Fixed Indexed Annuities

Before deciding to invest in a fixed indexed annuity, think through your options and prepare to ask lots of questions. An annuity can be a big investment; make sure you're clear at every step.

1. Determine your needs. Decide what type of annuity you want, how much you'd like to invest and how much income you expect (and for how long). Your annuity should be part of a larger financial plan for retirement. Consider working with a financial advisor who can help you put the puzzle pieces together.
2. Find a provider. Annuities are issued by insurance companies. You can seek out insurance companies directly, or work with a brokerage, bank, mutual fund company, independent agent or financial advisor that can guide you in the right direction.
3. Compare your options. Check rates, terms, available riders, fees, features and minimums to help determine which annuity works for you. Also check the financial health of the insurance company offering the annuity. Your future payouts are guaranteed by the insurance company that issues your annuity, so make sure you're working with a company that will be around for the long term.
4. Review your contract. Annuity contracts can be complicated; don't hesitate to get help. An experienced agent or financial advisor can go over contract details with you and explain how next steps will work.
5. Sign it and start funding. Once you've signed your annuity contract, you're ready to start funding it and—eventually—reaping the guaranteed benefits.

Learn more: How to Buy an Annuity

Alternatives to Fixed Indexed Annuities

You can invest your retirement funds in any number of stocks, mutual funds, exchange-traded funds and more. In fact, having a diversified portfolio of investments is generally a good idea. If you want an investment that shares some similarities to a fixed index annuity, consider these options:

• Registered index-linked annuities (RILAs): RILAs are similar to fixed index annuities but generally offer more upside—and downside—participation. An RILA also links to a market index, like a fixed index annuity, but it also lets you customize your gain and loss limits.
• Variable annuities: A variable annuity invests directly in the market and offers fewer risk limitations than a fixed index annuity, though you may still be able to get optional riders to protect your investment or guarantee income.
• Index funds: Index funds invest in the same assets that comprise a market index like the S&P 500 or the Russell 2000. Index funds typically have low fees and tax-efficient management, but they don't offer the risk protections or guaranteed payments of an annuity.
• Bonds: Bonds can provide income with some tax benefits, but they can also lose value when interest rates rise. Bond rates often meet or beat savings accounts and CDs, but still may not beat inflation over the long term. Finally, some bonds run the risk of being called early, versus annuities that are guaranteed for a term—or for life.

Learn more: How to Save Money for Retirement

The Bottom Line

Fixed indexed annuities can be a compelling addition to your retirement portfolio. Indeed, it's hard to find market-based gains, guaranteed minimum returns and a steady retirement income stream in any other single, tax-advantaged investment.

On the other hand, fixed indexed annuities can be complicated, inside and out. If you need help understanding your contract and how it fits into your larger retirement plans, working with a financial advisor may be of great help. Optimizing your retirement finances can be complex, but you don't have to do it alone.