Indexed Annuities
Indexed annuities earn interest with a guaranteed return based on an external index, combining growth potential with principal protection.
What is an Indexed Annuity?
Annuities are long-term investments that can help secure your financial future. All annuities earn interest over time, and indexed annuities earn interest with a guaranteed return based on an external index.
In exchange for a lump sum or periodic payments, an indexed annuity owner will receive payments at a later date for a set period of time, including any additional income earned from the external index. While primarily used to finance retirement funds, annuities can also be used to renovate a home or pay for college tuition.
Key Features:
- Returns linked to external market index
- Guaranteed minimum rate of return
- Protection against market declines
- Tax-deferred growth on earnings
- Penalty-free withdrawals up to 10% annually
How Does an Indexed Annuity Work?
Indexed annuities — also known as fixed indexed annuities or equity indexed annuities — are meant to provide a reliable stream of income throughout an annuitant's life. They can be purchased through an issuing insurance company in exchange for a one-time lump sum or periodic premium payments.
As with variable annuities, indexed annuity owners can invest in the stock market through an external index. As a result, they can earn a higher rate of return based on positive index performance. What sets indexed annuities apart is the added protection provided against market declines — if the market declines, you are still guaranteed to receive a minimum return.
Participation Rate
Insurance companies include a participation rate — the amount the contract will grow based on the index's percentage increase. For example, if the participation rate is 80% and the index increases by 10%, the return credited would be 8%.
Cap Rate
Most indexed annuity contracts include a cap on gained interest. If there is a 10% cap and the index increases by 55%, the maximum return an annuitant will receive is 10%. This limits upside but provides stability.
Fixed vs. Fixed-Indexed Annuity
Understanding the differences between these two annuity types can help you make the right choice for your financial goals.
Fixed Annuity
A fixed annuity contract guarantees a set rate of return on every disbursement. The amount does not fluctuate and the payout terms are predetermined prior to disbursement.
- Guaranteed fixed rate of return
- Consistent, predictable payments
- No market exposure
Fixed-Indexed Annuity
Similar to fixed annuities, an indexed annuity guarantees a minimum rate of return. But it also provides the opportunity to receive a higher rate if the index performs positively.
- Guaranteed minimum return
- Potential for higher returns
- Protection from market losses
Pros and Cons of Indexed Annuities
Indexed annuities are a low-risk alternative to variable annuities. Consider these factors before investing.
Pros
Guaranteed Income
Receive a reliable stream of income throughout your life
Potentially Higher Returns
Benefit from positive market index performance
Principal Protection
Full protection from volatile stock market declines
Tax-Deferred Growth
Your investment grows without immediate taxation
Market Investment
Opportunity to invest in outside markets with less risk
Cons
Low Cap Rates
Limits on maximum interest you can earn
Participation Rates
You only receive a percentage of index gains
Withdrawal Fees
Surrender charges apply for early withdrawals
Inflexible Terms
Contract terms are difficult to alter once signed
Complexity
Terms and calculations can be difficult to understand
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