What Is An Index Annuity? (2024)

An index annuity is an annuity whose rate of return is based on a stock market index, such as the S&P 500. Unlike most variable annuities, an indexed annuity sets limits on your potential gains and losses, so these annuity contracts are less risky than investing directly in the market but also have less upside.

How Does an Index Annuity Work?

Like most annuities, index annuities can provide you with a steady stream of income in retirement. Before you start receiving any income, though, you must first agree to and fund a contract. Your contract will spell out how you will fund your annuity—all at once with a lump sum or with steady payments over time—and when you can begin to make withdrawals.

The annuity company will invest your money using the index you select.The exact indexes available depend on the annuity company, but common indexes include the , the Nasdaq 100, the Russell 2000 and the Euro Stoxx 50. You can put all your money in one index or split it across several.

Equity indexed annuitiesmay be safer than investing directly in index funds, because the annuity company protects you against losses. That, of course, comes with the tradeoff that you won’t earn the same high returns that an index fund outside of an annuity might have.

Index annuities also benefit from tax-advantaged status, similar to 401(k)sor IRAs. This means your investment returns will grow tax-deferred until you withdraw them.

Index Annuity Returns

The amount your indexed annuity earns is based on the underlying index.

Let’s say you buy an S&P 500 index annuity. When that market goes up, you make more money, but when the market goes down, you earn less and may even lose money. The long-term annual average rate of return for the S&P 500 is about 10%. But you won’t see quite that return on your investment.

Index annuities don’t pay out the exact return of the index. Instead, they use a system to limit both your potential losses and your potential gains. That’s why this product is also called a fixed index annuity—because your losses and gains fall within a fixed limit.These limits are normally set using a combination of the following:

• Minimum guaranteed return. The annuity company could guarantee a baseline minimum return each year, even if the underlying index loses money. For example, it might pay 1% even if your target index has a negative return for the year.
• Loss floor. Your contract may also include a loss floor, which is the most you could lose in a market downturn. A contract might set your floor at 10%, which means 10% would be the most of your deposit you could lose from market losses.
• Adjusted value. Your index annuity may lock in your gains periodically. In other words, if your balance goes up, the annuity company could guarantee that it would not fall below that new adjusted value, even if the index loses money in the future.
• Return caps. On the other end, the annuity company might set a maximum possible return per year. For example, the most you could earn might be 6% per year, even if the underlying index earns more.
• Participation rate. Participation rate describes the percentage of index returns that the annuity will pay. If your participation rate was 70%, you would only receive 70% of the index gains. If the index went up 10%, you’d receive 7% (10% x 70%).
• Spread/margin/asset fees. The annuity company may deduct a fee from the index return. If its fee were 4% and the index returned 10%, your gain would be 6% (10% minus 4%).

Your actual index annuity could contain any combination of these caps and fees. Accounting for various caps and participation rates, annuity market research company Cannexestimated in 2018 that over seven years an index annuity might yield 3.26% on average annually. That said, rates of returns will greatly vary based on the stipulations of your annuity contract.

Index AnnuityWithdrawals

Besides growing your savings, one of the appeals of an index annuity is the income it can generate for you. Index annuity payments can last over a set number of years or can be guaranteed for your entire life, depending on your contract. Like most tax-advantaged retirement accounts, investment gains are taxed upon withdrawal.

Payments for index annuities are classified in two main ways: An immediate annuity starts paying money back to you within a year of you signing up. A deferred annuity, on the other hand, holds onto your money for at least a year before distributing payments. The longer you wait, the more the index annuity will grow your balance and therefore the greater potential future payments you’ll have.

Early Index Annuity Withdrawals

If you need to make an unexpected large withdrawal, you can—but it may cost you. Any payment from an annuity is taxed, and, depending on how long you’ve held your annuity, you could be subject to a surrender penalty that costs about 7% of your withdrawal.

The surrender period typically lasts between five to seven years as index annuities are considered long-term investments. If you need to make a large withdrawal from your annuity before age 59 ½, you may also incur a 10% penalty from the IRS.

Index Annuity Costs

After you purchase an index annuity, your annuity company deducts several charges from your balance and your investment earnings each year:

• Return limits. Whether the annuity company uses a return cap, a participation rate, a spread/margin/asset fees, or any combination of the above, it will be keeping part of the index investment return.
• Mortality and expense fees (M&E fees). Annuities charge M&E fees to cover the future income they guarantee. Part of this cost may also go towards the commission of the agent who sold you the contract.
• Administrative expenses. The annuity may charge an administration fee for managing the contract.
• Rider fees. Riders are extra benefits you can purchase for the annuity. For example, you could buy a rider that guarantees a minimum level of monthly income in the future, no matter how badly the index investment performs. You need to pay an extra annual fee for each rider.
• Surrender charge. Your index annuity might have a surrender period of between five and seven years—and possibly even longer. If you make a lump sum withdrawal or cancel the contract before then, the annuity company could charge a surrender fee of around 7% your balance. This fee may go down over time. For example, a 7% surrender fee might drop a percentage point each year until it’s gone.

Benefits of Index Annuities

• Moderatereturn potential. By investing your money in stock market indexes, an index annuity can have a decent long-term return, potentially better than what’d you receive through a bank certificate of deposit (CD), fixed annuitiesand savings accounts.
• Protection against market losses. The index annuity protects your savings against losses, making it a relatively safe investment. You get some market upside with less of the risk.
• Potential preservation of market gains. Your contract could lock in your gains periodically, like once a year. That way you don’t have to worry about future market downturns erasing your earnings.
• Inflation protection. The historic long-term return of the stock market is higher than inflation, so index annuities can protect the future buying power of your savings.

Drawbacks of Index Annuities

• Limit on gains. Index annuities do not have the same upside as if you invested in the market directly or if you invested in a variable annuity because the annuity company caps your potential gains.
• Complicated contract language and regulations. Given their various caps and participation rates, figuring out your return and other features can be complicated. Fixed annuities are generally much easier to understand.
• High fees. Index annuities charge a number of fees. These can cost you more than if you invested through index funds on your own through a retirement plan or a brokerage account, though those options don’t offer the loss protection of index annuities.
• Unpredictable return. Your index annuity return ultimately depends on the performance of the index. If there’s a bad market stretch, you might earn very little compared to accounts that pay a guaranteed annual return.

Index Annuity vs. Variable Annuity

Like an index annuity, avariable annuity also puts your money in stock market funds and indexes. It doesn’t, however, include the same limits on gains and losses as an index annuity. This grants you the potential for higher gains but also higher losses.

If you’re investing for the long-term and can handle waiting out market swings, you could potentially earn more with a variable annuity. An index annuity is better if you want some market exposure without the chance of a big loss, even if it means not earning as much in good years.

Index Annuity vs. Fixed Annuity

A fixed annuity pays a set return each year that’s partially guaranteed by the annuity company. It’s more like a bank CD or a savings account because you can predict how your money will grow without worrying about what’s going on in the stock market. This certainty, however, comes at a cost: In the long-run, a fixed annuity will likely earn less than an indexed annuity.

If you have a short-term goal or just want to grow your money by a definite amount, a fixed annuitycould be a good choice. If you want more growth and don’t mind a little more short-term unpredictability, an indexed annuity could be better.

Who Is an Indexed Annuity Good For?

An indexed annuity is best for someone who wants to invest the stock market but is worried about losses. With these contracts, you get some market upside without having to worry about a bad downswing.

Index annuities are also a better choice for medium and long-term savings goals. This way you can wait out a temporary market downturn so that you can then earn higher long-term index returns.

For short-term goals or situations where you absolutely need some earnings over the next few years, you may be better off with something that offers more of a guaranteed return, like a fixed annuity or a CD. On the other end, if you want the highest possible return and don’t mind more risk, you could potentially earn even more with variable annuity or a direct investment in the stock market.

Indexed annuities are some of the more complicated investment products out there. If you need help understanding the terms, consider meeting with a fee-only financial advisor to determine what, if any, kind of annuity is right for you.