What is an Indexed Annuity?

Preserving Retirement Assets

An indexed annuity – also called a fixed indexed annuity or equity indexed annuity – is a type of annuity that is tied to an underlying stock market index, such as the S&P 500. Indexed annuities are typically funded by a lump sum of money to an insurance company that will issue the annuity contract. In an indexed annuity, the growth of the annuity is based on the performance of the underlying index rather than a fixed interest rate.

In an indexed annuity, the returns are usually limited by either a cap on the gains in a given year, or only allowing a percentage of participation in the underlying index. For example, an indexed annuity might have a cap of 8%, which means that even if the underlying index grows by 10% in a given year, the growth on the annuity for that year would be 8%.  Or, if the participation rate was 70%, and the underlying index grew by 10% in a given year, the growth on the annuity would be 7%.  However, there is downside protection in indexed annuities, meaning if the underlying index went down by 15% in a given year, the annuity would simply not grow for that year, but would also not suffer any loss of principal.

One primary benefit of an indexed annuity is the potential for higher returns than a traditional fixed annuity. In a traditional fixed annuity, or multi-year guaranteed annuity, the interest rate will be locked in for the length of the contract.  In an indexed annuity, the growth will depend on the performance of the underlying index, and will return different amounts each year depending on that performance.  However, indexed annuities are designed to outperform the growth on a multi-year guaranteed annuity over a longer time horizon.

Another great benefit of indexed annuities is tax-deferred growth, meaning you don’t pay taxes on the growth of your investment until you actually withdraw the money. This can make a big difference if you’re investing for the long-term, since the tax deferral savings can add up over a long period of time.

Indexed annuities are not fully liquid, and usually come with a surrender charge if you withdraw more than the free withdrawal amount or surrender the annuity before the end of the contract. This surrender period can be anywhere from 5-10 years, or more.  Generally speaking, the longer the contract, the higher the cap rates and participation rates and, therefore, the better the performance.

Indexed annuities are primarily used as a retirement savings vehicles and typically recommended for long term goals. These are complex contracts, so it is important to work with an experienced, independent advisor who understands the different products available with different annuity companies.

Share This: