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. In return, an annuity owner is guaranteed to receive a predetermined payout stream.
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 from variable annuities is the added protection provided against market declines. Investing in a variable annuity comes with the risk of losing any additional interest if stocks and mutual funds perform poorly. With an indexed annuity, if the market declines you are still guaranteed to receive a minimum return.
However, there are constraints to any return on interest. Insurance companies include a participation rate for indexed annuity contracts, which is the amount the contract will grow based on the external index’s percentage increase. For example, if the annuity’s participation rate is 80 percent and the index increases by 10 percent, the rate of return credited to the annuity account would be 8 percent. In most cases, the participation rate is less than 100 percent and is based on the length of the annuity contract. In addition, most indexed annuity contracts include a cap on the gained interest. If there is a 10 percent cap, and the index increases by 55 percent, the maximum return an annuitant will receive is 10 percent.
Similar to many annuities, indexed annuity contracts are difficult to alter. In the event an annuitant needs funds for an unexpected emergency, insurance companies will charge surrender fees if withdrawn before the disbursement period. However, many annuity contracts offer penalty-free annual withdrawals for up to 10 percent of the initial value.