Fixed Index Annuity Basics
July 19, 2023
Blueprint Income Team
A fixed index annuity exposes your portfolio to potential market index gains. This kind of annuity blends the security of a fixed annuity with the potential of higher returns by linking the interest rate to a market index, like the S&P 500. It's important to understand how these annuities work to see if they can benefit you in the future.
Let's unpack the basics of fixed index annuities. This will include what they are and how they work so that you can decide if this is the right type of annuity for your financial goals.
What is a fixed index annuity?
A fixed index annuity blends the security of a fixed annuity with some of the upside potential that can come with index investing. This kind of annuity comes with principal protection and can generally be annuitized, or paid out, for income purposes at any time, although some providers may have an initial period during which you cannot annuitize. However, this annuity differs from a fixed annuity when it comes to how it earns interest.
Fixed index annuities credit interest based, in part, on the performance of a market index. This helps your annuity grow based on the associated market's performance index, while still protecting your principal.
How does it work?
A fixed index annuity operates along the same basic structure as other kinds of annuities. You can make contributions to the annuity that grow tax-deferred. The contributions and growth happen during what is called the accumulation phase. The unique aspect of a fixed index annuity is how the annuity grows your contributions until the payout phase of the contract.
The earnings of a fixed indexed annuity are dependent on the performance of the underlying index option selected and the crediting strategy applied to the index. A crediting strategy determines how much of the index's actual return the owner of the annuity receives. These strategies most often come in the form of a participation rate or a cap on the actual performance of the underlying index. For example, growth may be capped at 8% per year or participate in 80% of the index's performance, or a combination of the two.
When the market index rises, it can have a positive effect on your annuity's earnings. The same relationship exists when the market is down. However, fixed index annuities can come with a variety of loss protection features, such as a guaranteed minimum interest rate, a floor on potential losses, or an income rider that provides a guaranteed income stream regardless of market performance. The specific loss protection features will depend on the terms of the annuity contract. This minimum rate is contractual and is always operating in the background as your money is invested.
There are several benefits of contributing to an annuity:
Higher potential returns
A fixed index annuity's return is linked to a market index. When the market index rises, your annuity's interest rate rises along with it (with certain limits, as mentioned above). This potential growth means that a fixed index annuity could outperform more conservative annuities whose interests are not credited based on a market index.
Contributions made to a fixed index annuity are protected by the insurance company that you bought the annuity from.
The growth of a fixed index annuity is tax-deferred, allowing your annuity to grow faster than an asset whose growth is taxed each year. When you decide to receive payments from your annuity in the future, or withdraw your money, some or all of those payment amounts will be taxed as ordinary income, depending on whether you funded your annuity with pre-tax or post-tax dollars.
The primary risk of a fixed index annuity is the market-linked interest rate. If the market goes down, your annuity's earnings can drop down to the minimum interest rate. In this case, your annuity could grow at a slower rate or not at all as compared to other kinds of annuities.
How to choose a fixed index annuity
Consider the following to help you choose the best annuity option.
Factors to consider
When it comes to finding a fixed index annuity, there are a few important factors to consider. These factors will help you understand the annuity to see if it aligns with your personal and financial goals.
The participation rate is instrumental in defining the relationship between your annuity's earnings and the actual return of the market index to which it's linked. If the participation rate is 80%, and the market index were to increase by 10%, your annuity's actual earnings would be 8%.
Many insurance companies will offer a cap rate that limits the return potential of the underlying index. If the cap rate is set at 7% and the market index increases by 10%, your annuity's earnings will be limited by its cap rate which, in this example, would be 7%.
Asset fees (margin or spread)
Fixed index annuities typically do not have upfront fees, but they may have ongoing fees such as annual contract fees, administrative fees, or rider fees. These fees can vary by insurance company and annuity contract. Insurance companies may also charge margin fees, also called spread fees, which occur when the insurance company keeps the spread between the index's return and whatever the cap or participation rate is. For example, if the annuity's linked market index earns an 8% return and the insurance company charges a 3% spread fee, your actual earnings from the annuity would be 5%.
Comparison with other types of annuities
Fixed index annuities offer both principal protection and the potential for higher returns than a traditional fixed annuity, but they offer lower potential returns than a variable annuity. The exact return potential will depend on the specific terms of the annuity contract, including the participation rate and cap rate. When you compare this kind of annuity with others, a fixed index annuity may be a great option for those who want the best of both worlds.
While it's true that the potential returns may not be as high as what can be found with variable annuities, the added security of guaranteed principal protection may make up for it.
Frequently asked questions about fixed index annuities
Here are answers to some common questions about fixed indexed annuities.
What happens if the market goes down?
A fixed index annuity's returns are linked to a market index. However, it also comes with a principal guarantee. This guarantee means that your capital and future income stream potential are still protected and guaranteed. Note that the fees an annuity charges may reduce your principal, regardless of what interest, if any, is credited.
Can I withdraw my money anytime?
Early withdrawals from a fixed index annuity can result in penalties and fees. Most insurance companies will have a surrender period in your contract. This is a period of time when penalties can be given for withdrawals beyond those allowed by your contract. These fees are generally a percentage of the asset value, and they decrease over time.
As an example, if you were to have a 10-year surrender period, the penalty could be 10% in the first year, 9% in the second, 8% in the third, and all the way down to 0% in the 10th year.
How is the income stream taxed?
Earnings within a fixed index annuity are tax-deferred. This deferment allows the annuity to defer all tax liability until a taxable withdrawal is made. Earnings will then be taxed as ordinary income. This allows funds to grow faster than an asset whose earnings are taxed each year, all things being equal.
Is a fixed index annuity right for me?
Before taking any annuity, it's vital to ensure that the annuity aligns with your personal and financial goals. A fixed index annuity may be ideal for those who want to protect and grow their capital for the future. Here's a quick checklist of who can benefit the most from fixed index annuities.
- You have funds that you want to invest for at least five years.
- You want to grow your money to secure an income for yourself during retirement.
- You appreciate the security of a fixed annuity but want the potential of a higher interest rate.
If you're interested in learning more about fixed index annuities, our team at Blueprint Income is here to help. Visit our website for more information, or start your investment journey today with our innovative guide.
Blueprint Income Team
We are a team of finance, insurance, and actuarial professionals working to make it easier for everyone to achieve a steady and comfortable retirement. We write about annuities (the good and the bad) and provide strategies to help Americans prepare for retirement.