Understanding Fixed Index Annuities
Nov 28, 2023
Blueprint Income Team
Market indexes can be designed to track stocks, industries, and even entire economic markets.
There are thousands of market indexes in the United States. While the popular S&P 500 tracks 500 of the largest corporations in the United States, there are others that track entire industries like the Dow Jones U.S. Real Estate Index. These indexes have many diverse holdings, which can reduce risk while tracking a specific market.
Fixed index annuities balance the principal protection benefits of a fixed annuity with some of the upside potential commonly attributed to variable annuities as the returns are linked, in part, to the performance of a market index.
Let's take this opportunity to dive deeper into fixed index annuities to learn about the basics of what these annuities are, how they work, and their benefits. By gaining a good understanding of fixed index annuities, you can make the best decision for your retirement.
Table of Contents
- What is a fixed index annuity?
- Return caps
- How does it work?
- Fees (margin or spread)
- Differences between a fixed and fixed index annuity
- Frequently asked questions about fixed index annuities
- Benefits of a fixed index annuity
- What happens if the market goes down?
- Income rider availability
- What happens when I want to make a withdrawal?
- Principal protection
- What is a surrender period?
- Tax deferral
- How can early withdrawal affect my income stream?
- Beneficiary provisions
- How is the income stream taxed?
- Factors to consider
- Thinking about getting a fixed index annuity?
- Available indexes
- Is a fixed index annuity right for me?
- Participation rates
- Final thoughts
What is a fixed index annuity?
A fixed index annuity is a type of annuity that links its returns to a chosen market index. Once you choose a market index, your annuity can be exposed to a portion of the possible growth of that market index, with the potential of earning higher returns as compared to other kinds of annuities like fixed annuities, which offer only a fixed interest rate.
Fixed index annuities come with principal protection features that can shield your principal contribution from loss. This adds financial security and makes fixed index annuities a great long-term option for those who want to protect their principal contribution and grow their annuity for the future.
How does it work?
A fixed index annuity is a great way to expose your annuity to higher potential returns. Fixed index annuities work by linking the interest credited to the contract owner's contributions to the performance of a chosen market index. The returns of the chosen market index are then assessed against a segment option such as a cap rate or participation rate. These segment options simply limit how much of the market's return you, as the annuity owner, will actually receive.
As an example, if you were to choose to link your fixed index annuity to the S&P 500, and the market index was to rise by 10%, your annuity's overall return would not equal the total return of the index but would get assessed against a cap or participation rate applied to the index's return. If the participation rate is 70%, your return will be exposed to 70% of the market's movements, so your annuity would earn 7% interest. However, if the return is subject to the cap rate and the cap rate is set at 6%, your return would then be limited to 6%.
Differences between a fixed and fixed index annuity
As mentioned above, a fixed index annuity comes with the principal protection benefits of a fixed annuity. While fixed annuities come with fixed interest rates, a fixed index annuity offers the potential for greater returns. The returns of a fixed index annuity are linked to the performance of a chosen market index. This exposes your annuity, in part, to market-related performance.
Benefits of a fixed index annuity
There are several benefits that come with a fixed index annuity. Here's a quick look at the most notable benefits and how they can come in handy during your retirement.
Income rider availability
Many insurance companies offer income riders as an elective benefit. An income rider guarantees that no matter the underlying index's performance, should you decide to start taking income from the annuity in the future, your income payments will be based on the greater of either the index's performance or a minimum fixed rate.
When you have a fixed index annuity, your original contribution can be guaranteed against loss. This means added financial security while building your wealth for retirement.
Earnings in a fixed annuity are tax-deferred until they're withdrawn. This means that, during the accumulation phase, you will not owe taxes on your earnings. This can allow your annuity to grow more quickly than an investment whose earnings are taxed every year.
A fixed index annuity generally comes with beneficiary provisions. If the owner dies during the accumulation phase of the annuity, the named beneficiary (or beneficiaries) will be able to receive the value of the annuity outside of the owner's estate, avoiding the process of probate.
During the income phase of the annuity, the terms of the contract may specify a minimum number of payments that the company will make. If the owner dies before the minimum number of payments has been made, the beneficiary can receive the remainder of the income payments.
Factors to consider
When it comes to finding the ideal fixed index annuity, there are a few factors to keep in mind. This will help you find the right annuity for your personal and financial goals.
Most insurance companies will offer a few indexes for you to choose from. However, the most popular are the larger indexes like the S&P 500, the Dow Jones Industrial Average, and the NASDAQ Composite.
The participation rate is a key metric that helps you understand how much exposure your annuity has with the chosen index. If your participation rate is 80%, this means that your annuity would be credited with 80% of the change in the market index. In this case, if the market index were to increase by 10% during an interest crediting period, your annuity would earn 8%.
Return caps are a segment option that may be available on the underlying index option of your fixed index annuity. The return cap is the maximum return that your annuity can achieve based on the performance of the underlying market index. For example, if the return cap is set at 10% and the market index goes up by 12% during an interest crediting period, your annuity will earn the return cap of 10%.
Fees (margin or spread)
Fixed index annuities don't charge fees like other financial products. However, the spread among the cap, the participation rate, and the actual return of the market index are "costs." If the index returns 10%, but the cap rate is 7%, the insurance company will keep a portion of that 3% difference. The same principle applies to the participation rate.
Frequently asked questions about fixed index annuities
It's important to understand every aspect of fixed index annuities before you make any financial decisions. Here's a quick rundown of the most frequently asked questions about this type of annuity.
What happens if the market goes down?
Fixed index annuities have protections in place to preserve your principal contribution and credited earnings even when the market is down. Future earnings in a fixed index annuity fluctuate depending on the performance of the market index that you have chosen. Should the return of the market index be negative during an interest crediting period, fixed index annuities guarantee you against loss.
What happens when I want to make a withdrawal?
A fixed index annuity is designed to provide you with security over an extended period of time. However, there may be instances where you need to withdraw your capital early. Here's what you need to know about withdrawing.
What is a surrender period?
The surrender period is a specific time period in which a penalty may be assessed for surrendering an annuity early. The surrender period is generally for a stated time period, which is agreed upon at the time of application. This is typically expressed as a percentage of the account value and declines over time.
An example of this would be if you had a seven-year surrender period with the penalty going from 9% in the first year to 8% in the second year, 6% in the third year, and down to 0% in the seventh year. Surrender penalties may also be assessed on withdrawals that exceed a contract's free allowable amount (e.g., 10% of the contract value). However, it's important to note that not all fixed index annuities have free withdrawal provisions.
How can early withdrawal affect my income stream?
When you withdraw from your fixed index annuity early, you could face a surrender penalty. However, withdrawing early can also have an impact on the payout phase of your annuity should you decide to use this annuity for income purposes. Early withdrawals will impact the value of the annuity and reduce future payments.
How is the income stream taxed?
When you contribute after-tax money to a fixed index annuity, the earnings may grow in the annuity tax-deferred. This means that the tax obligation is postponed until you withdraw or receive payments from the annuity. The payout phase is when you start withdrawing income from the annuity. The earnings portion of these payments is generally taxed as ordinary income.
Thinking about getting a fixed index annuity?
A fixed index annuity can be a valuable component of your retirement portfolio. Find out whether you're likely to benefit from this tool below.
Is a fixed index annuity right for me?
When it comes to finding an annuity, it's important to choose one that aligns with your personal and financial goals. A fixed index annuity balances the security of a fixed annuity with some of the upside potential of a variable annuity. This makes it ideal for those who want to expose their annuity to the market for higher potential returns than a fixed annuity.
- A fixed index annuity can be ideal for those looking to balance protecting and growing their capital for retirement.
- A fixed index annuity is linked to a market index and can offer a fluctuating rate of return depending on how well the underlying index performs.
- Earnings are tax-deferred, allowing the annuity's interest to compound at a faster rate.
- A portion of future income payments will be taxed as ordinary income during your retirement.
If you want to learn more about the various annuities you can get for your retirement, our team at Blueprint Income is here to help. Visit our website for more information, or start your journey today with our intuitive 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.