What Is a Fixed Indexed Annuity & How Does It Work? - SmartAsset

Annuities come in many different forms, and fixed indexed annuities offer the chance to combine other annuities’ benefits. Rather than rely solely on a fixed interest rate or the performance of a market index, this annuity combines both. While the insurance company itself determines fixed rates, annuitants will be able to choose the index they want their assets to follow. However, these dollars don’t literally go into the index, which means you won’t lose any money if the index loses value. A financial advisor can help answer your questions about whether or not a fixed indexed annuity is good for you.

How Fixed Indexed Annuities Work

A fixed indexed annuity is a long-term savings insurance contract that offers two ways of earning interest, also called crediting strategies. The strategy with the lowest risk and upside is the “fixed” part of the annuity. For this, the insurance company offers a fixed interest rate for a specific number of years, similar to a certificate of deposit (CD). Often the initial rate is for just one year. The rate then resets, usually annually, but it will never go lower than the minimum rate the company guarantees.

The other crediting strategy, which offers more upside, is the “index” part of the annuity. Money in this part of your account will earn interest based on the performance of an index, such as the S&P 500. But these rates generally have restrictions around them, some of which are helpful and some of which aren’t.

For starters, because your money doesn’t actually go into the index fund, insurance companies will usually offer a 0% floor. That means the worst your money can do is not grow at all and stay the same. However, there are also participation rates and rate caps, which can limit how strong your returns can be. Here’s how each works:

Rate cap: If your contract has a 6% rate cap, that’s the max return you can receive. So even if the index garners 9% in returns, the best you’ll do is 6%.
Participation rate: For contracts with a participation rate, you’ll receive a certain percentage of the growth your index experiences. So if your contract has a 50% participation rate and your index grows by 8%, you get 4% in returns.

Once your account is open, you can decide how much you want to allocate to each strategy. Often, there are several index strategy options, so you can allocate your money to more than one. Any money you don’t attribute to an index will grow through your contract’s current fixed rate.

Because annuities are retirement savings products, their withdrawal rules are quite stringent. As a result, insurance companies typically punish you with hefty withdrawal charges if you take money from your account before the contract’s terms stipulate you can. In addition, the IRS will charge you a 10% early withdrawal penalty if you withdraw from your account before you turn 59.5 years of age.

How to Invest in a Fixed Indexed Annuity

The first thing to do when wanting to invest in a fixed indexed annuity is to set up, or buy, an annuity contract. You’ll have to transfer funds to the annuity contract and then choose an index to invest in. You can transfer funds in one lump sum directly from your bank, make smaller transfers over a period of time, or make a direct transfer from your retirement account.

Many fixed index annuities will have a minimum initial investment amount and a minimum additional investment amount. For example, an annuity at Charles Schab may have an initial investment amount of $100,000 with an additional investment amount of $1,000. So this means the first time you invest in the annuity you have to put up the $100,000 but can invest much smaller increments down the road.

Your biggest decision will be how you direct the annuity company to invest your funds. You can choose to invest in a single index or spread your money out over several indexes. This choice will likely depend on what your goals are with the investment. It’s important to study the contract as a fixed indexed annuity could behave a certain way that you may not be expecting.

Pros of a Fixed Indexed Annuity

Perhaps the best benefit of a fixed indexed annuity is that it’s protected from the volatility of the market. As we stated above, your money is never actually in the stock market. Your crediting strategy tracks the stock market, but you don’t own securities that can fall in value. In turn, you don’t have to worry about losing funds.

Some of the other benefits of a fixed indexed annuity are:

Affordable: Fixed indexed annuities are some of the cheapest retirement savings products there are. In fact, they usually don’t have any annual fees whatsoever. With some contracts, you may have the ability to buy benefit riders, which extend your coverage in areas like death benefits and income. So if you take advantage of these, you’ll likely incur a fee. Even still, compared to variable annuities, fixed indexed contracts are extremely low-cost.
Higher Fixed Rate: To entice buyers, insurance companies will often offer a high initial fixed interest rate. Sometimes this high rate is “enhanced” or “boosted,” so it may only be for a year though. The insurance company also guarantees a minimum interest rate. This can be appealing in an environment where interest rates are less than 1%, as most caps are 1%.
Lifetime Payout Benefits: Additionally, once you turn your nest egg into an income stream, you cannot outlive that income stream. This, of course, assumes you choose the lifetime payout option. This is important, as life expectancies rise and Social Security benefits will likely change. Should you die before you annuitize, the insurance company will pay a death benefit equal to the number of your payments, minus any withdrawals and taxes.
Joint Contract Option: Fixed indexed annuities can be opened as joint contracts. If you decide to go this route, you or your spouse will take over the contract should either of you pass away. This level of protection can be comforting, as it ensures your money will stay in your family.

Cons of a Fixed Indexed Annuity

A fixed indexed annuity’s trade-off for being low-risk is fairly mediocre growth potential. That’s because even if an index performs exceptionally well, you’ll likely miss out on some of those returns due to rate caps or participation rates. These are unfortunately unavoidable, though you can shop around to find the best terms.

Some of the other cons of a fixed index annuity are:

Can Be Counterintuitive: If you want to avoid restrictions altogether, you’ll need to invest in the funds directly through the market. Of course, if you do that, you’ll miss out on the tax-deferred benefits of an annuity. You’ll also encounter more risk, though index funds are generally reliable.
Slower Asset Growth: Fixed indexed annuities may be lower risk than many investments, but they still come with some risk. That’s because while you can actually lose money with investments, the potential for 0% returns with a fixed indexed contract will still slow your asset growth. Although losing your cash is undeniably worse, your retirement funds will still end up being hurt.
Can Lose Buying Power: Another potential issue with fixed indexed annuities is that if your returns grow at a slow rate, you run the risk of losing buying power due to inflation. So even if you technically gain, your money may not have kept up with inflation, which means you still lost some value.

Fixed Indexed Annuities vs. Other Types of Annuities

If you’re buying an annuity, it’s important to figure out what type of contract is best for you. There are four main types of annuities: fixed annuities, variable annuities, fixed indexed annuities and indexed annuities.

Fixed indexed annuities offer a “fixed account” that allows contract holders to take advantage of a predetermined interest rate. A fixed annuity works exactly like this, only it doesn’t come with an indexed account too. While that might make them seem obsolete compared to a fixed indexed annuity, they sometimes offer better fixed rates due to their overall lower growth potential. So if you’re planning on allocating most of your money into your fixed account anyway, a fixed annuity might be a better option.

Indexed annuities are much the same, as they share an indexed feature with fixed indexed annuities, only they’re lacking a fixed account. The main perk an indexed annuity might offer over a fixed indexed annuity is stronger earnings caps and participation rates. That makes it the preferable option for those more focused on indexing their assets.

Of course, fixed indexed annuities are the best of both worlds. They offer the most flexibility of any annuity type, which is no doubt a benefit that fits many people’s needs. So if you want to tinker with the allocation of your money, perhaps the fixed indexed annuity is the way to go.

Variable annuities offer the best return potential of any annuity type. That’s because they are completely centered around investing. They allow you to physically invest your money in a fund rather than have your assets index its performance. This feature is also the downfall of the variable annuity, as it makes them extremely risky contracts.

Bottom Line

Fixed indexed annuities combine the low risk of a fixed annuity with the potential capped returns of a variable annuity. But the tradeoff for less risk is less growth. It should also be noted that these annuities are low-risk, not no risk. Additionally, since an insurance company backs your fixed indexed annuity, all guarantees depend on its financial outlook.

Tips for Buying an Annuity

Annuities are complex financial products, so the help of a professional might be worth seeking out. Luckily, finding a financial advisor that can help you with your retirement plans doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and 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.
Check the financial outlook of an insurance company before buying an annuity. After all, if you’re counting on receiving payments for life, you should be sure the company will be around. The major financial rating agencies are Standard and Poor’s, Fitch and A.M. Best.