What Is an Indexed Annuity? - SmartReads by SmartAsset

First and foremost, indexed annuities, also called fixed indexed annuities, are products. Insurance companies design them to appeal to savers who are worried about stock market volatility but still crave market growth. That’s why you’ll often hear that indexed annuities have no downside and only upside – which isn’t always true. Or insurance agents will tout how fixed annuities combine the best of two worlds: the safety of fixed annuities and the return of variable annuities. Read on to learn what an indexed annuity is, how it differs from other annuities and whether it’s right for your retirement plan.

Indexed Annuity Defined

An indexed annuity is a long-term retirement product that combines features of fixed and variable annuities. It’s similar to fixed annuities in that it has a minimum return guarantee. However, that doesn’t always mean it’s impossible to lose money. For many indexed annuities, the minimum return guaranteed is 87.5% of the principal plus 1% to 3% interest.

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. In an overly simplified sense, 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.

Indexed annuities also go by a couple other names such as equity-indexed annuities (EIAs) and fixed-indexed annuities. The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) do not regulate them. Instead, state insurance departments do.

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

Indexed Annuity vs. Variable Annuity

As noted earlier, the indexed annuity shares features with the riskier variable annuity. Both options can bring you 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. Those 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 the two comes on the other end of the spectrum: not where you put your money in but what you get back. Indexed annuities come with a minimum return rate guarantee, while variable annuities do not. Because of this, indexed annuities are often marketed as a safer alternative to a variable annuity. This is true to an extent. 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.

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 instance, if the index increases by 10%, it’s unlikely that you will see a 10% return. First, your interest rate will likely have a cap. So even with a 10% increase in the index, your return never rises 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 6.0% interest rate, provided it doesn’t exceed your rate cap.

Or your interest rate could have a spread fee. This means you will receive the index rate minus the spread fee. So if the index gained 10% and your spread fee is 5%, you would be credited 5%.

Finally, these caps and participation rates are usually subject to change throughout the course of your annuity unless spelled out otherwise in your contract. 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’s extra important with these products to be completely aware of the details of the contract before you sign anything.

The Takeaway

An indexed annuity is not just a variable annuity with a minimum guarantee. It’s much more complex than that. However, the hybrid nature of the investment vehicle still makes it attractive to moderately aggressive investors who are looking for an annuity to help with their savings goals. They’re also subject to the same pros and cons of annuities.

With indexed annuities, it’s crucial to be clear-eyed about what you’re buying. You shouldn’t expect lucrative return rates, as that will likely just lead to disappointment. However, if you’re looking for a minimum rate guarantee and the potential for more, an indexed annuity could be right for you. As always, be sure to go over all the details of the contract with your insurer. Be aware of any caps, participation rates or other fees that could eat away at your returns.

Tips

It can be overwhelming to plan your retirement all by yourself. Consulting with a financial advisor who’s well-versed in the options can save a lot of time and stress. SmartAsset’s SmartAdvisor tool can match you with up to three financial advisors in your area who suit your needs.
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.