Indexed Annuity: A Comprehensive Guide

An annuity is a financial product offered by various financial institutions but most often purchased through an insurance company. It works through the investment of a lump sum payment or a range of smaller payments which convert into a guaranteed income later on, generally when the individual retires.

Indexed annuities are just one type of annuity and are slightly different from options like fixed and variable annuities. Let’s take a closer look at indexed annuities, what they are, and how they work.

How Does an Indexed Annuity Work?

When an aspiring policyholder (or annuitant) applies for an indexed annuity through an insurance company or other financial institution, they have to state whether they want to pay a lump sum or make monthly payments.

Depending on the insurance company, and the options on offer, the company will then invest the funds and offer an interest rate linked to the appropriate market index. This is what makes indexed annuities unique. Rather than having a fixed interest rate, the interest rate will depend on the performance of the given market index.

For instance, indexed annuities linked to the Dow Jones will offer better retirement income when the Dow Jones does well and will do more poorly when the Dow Jones isn’t performing well.

However, you’ll have guaranteed income payments when the policy matures. The only way that this won’t happen is if the issuing insurance company goes bankrupt and has no claims-paying ability.

How Do Fixed Indexed Annuities Work?

Fixed index annuities are a hybrid of fixed and indexed annuity plans. It’s worth mentioning here it has a similar function to indexed annuities. But, as the name suggests, the minimum interest rate is fixed. This means it will provide guaranteed income payments of at least a certain amount.

Elements of an Indexed Annuity

It’s generally possible to break most things down into their base elements in order to understand them better. In the case of Indexed annuities, this means different parts of the process, as well as different elements affecting how these policies work.

Initial Premium Payment

Whenever you take out an annuity, the insurance company or financial institution of your choice will expect an initial premium payment. This may be in the form of a lump sum, or it might take the form of a series of monthly payments. For all intents and purposes, this is the investment capital that gives your contract value.

Participation in Index Performance

With indexed annuity policies, the returns on the contract are directly linked to the market to which the annuity is linked. The insurance company, or annuity provider of your choice, will monitor the chosen index for a specific time period (typically a year or longer).

Calculation of Interest Credits

At the conclusion of each specified time period, the insurer or annuity provider will calculate the indexed annuity that needs to be ascribed to each policyholder. The interest credited may be subject to certain terms and conditions and is always based on the chosen market index’s performance during the designated timeframe.

Cap Rate or Participation

It’s common for indexed annuity policies, and even fixed index annuity policies, to have either a cap rate or a participation rate. Both of these can have significant effects on the annuity’s performance.

Cap Rate: This stipulation sets a cap on the amount of interest an annuity can earn during a given time period. If your cap rate is 6%, for example, your annuity policy can earn a maximum of 6% interest. Even if the index you choose is exceptionally well, and you could potentially have earned 10% interest, the cap rate means you’ll only earn 6%.
Participation Rate: The participation rate stipulates exactly how large a percentage of the index’s performance can be accredited as credit. For instance, if your indexed or fixed index annuity has a participation rate of 80%, that means you’ll receive 8% interest (as long as it doesn’t exceed the cap rate).

Adjusted Values

This is another term commonly used in indexed annuities and fixed index annuities. It refers to the fact that the financial institution will regularly adjust the value of your policy. This will happen after every pre-determined time period to keep the policy’s value up to date.

Minimum Interest Rate

As a method of protecting the annuitant, fixed index annuities and some general indexed annuities offer a guaranteed minimum interest rate. This ensures that, even if the index linked to the policy performs poorly, the customer will receive at least the minimum interest rate.

Accumulation Phase

During the accumulation phase, an annuity will build value based on the credited interest. This increase in value is tax deferred. Thanks to this advantage of a deferred annuity, you’ll only need to pay taxes when your annuity starts paying out or you make withdrawals.

Withdrawal Options

The withdrawal options on offer can vary significantly between one company and the next. However, many indexed annuities allow you to choose between multiple different options. For instance, you can choose to receive your payout in a lump sum or as a series of regular payments.

Is an Indexed Annuity Right for You?

While indexed annuities are wonderful, and suit many different people, however, they’re not for everybody. However, they might be right for you if:

You don’t like taking risks – If you’d like the benefits of a retirement income but also want to mitigate some of the potential risks, then indexed and fixed-indexed annuities are a wise choice. Thanks to the minimum interest rate, most policies have little to no risk.
You’re retired or going to retire soon – Thanks to the principal protection offered by this kind of policy, and the opportunity for market-linked growth, this type of deferred annuity is brilliant for retirees and those nearing retirement,
You’d like to see a balance between growth and stability – If you like the idea of a middle ground between fixed and variable annuities, then indexed annuities are ideal. They offer all the stability of a fixed annuity combined with the growth potential of variable annuity policies.
You have a longer investment horizon – This type of policy is ideal if you have the time that the policy needs to reach fruition.

Indexed Annuity Pros and Cons

There isn’t a financial product that doesn’t have advantages and disadvantages. Let’s take a closer look at some of the pros and cons of indexed annuities.

Pros

The potential for market-linked growth – Because indexed annuities are linked to the stock market, they have a higher potential for growth than some other types of annuities.
Guaranteed retirement income stream – Unless the life insurance company or financial institution hosting your annuity goes bankrupt, they have to pay out your annuity irrespective of their claims-paying ability.
Downside protection – Thanks to the guaranteed minimum interest rate accompanying most policies, these policies have a reasonable percentage of principal protection, making it hard to lose money. No matter how poorly the market performs, the financial institution must pay you at least the minimum promised interest on your initial investment.
Growth is tax-deferred – Indexed annuities offer tax-deferred growth (as do some other types of annuities). This means that you’ll only pay tax on the income made above and beyond your initial investment. You’ll also only start paying tax when you start making withdrawals or receiving payouts.

Cons

The limits imposed by cap rates and participation rates – While indexed annuities offer greater potential for growth than options like variable annuities, their caps still limit the growth potential substantially. The cap rate, for instance, limits the amount of interest you can receive. And participation rates mean you only receive a percentage of the profit generated by your investment.
The policies can seem complex and hard to understand – Due to the terms and conditions offered by different financial service providers; it can be difficult to fully comprehend the details of this type of policy.
Surrender charges and limited liquidity – If you take out this type of annuity, you’ll generally need to pay surrender fees if you want to access the funds before the policy matures. This can significantly limit your liquidity, and some policies make it incredibly difficult to access the funds at all.

Indexed Annuities Vs. Other Annuities

Most annuity contracts are similar in a way, but there are also an array of differences between them. Below, we’ll discuss the differences between a fixed annuity contract, a variable annuity contract, and an indexed annuity contract.

Fixed Annuity Contracts

The main difference between fixed annuities and indexed annuities is that fixed annuities will offer a guaranteed interest rate for a specified period. Since indexed annuities are linked to a stock market index or another form of a market index, the interest rates and corresponding income payments can vary significantly.

A fixed annuity contract is generally considered more conservative because it provides a more predictable, stable return irrespective of any fluctuations in the market. Generally, this type of retirement income is attractive to individuals who aren’t keen on risk.

Variable Annuity Contracts

A variable annuity allows you to invest your premiums in a wider range of stocks and markets. Since the returns are linked to the performance of these stocks, shares, and markets, there are no guaranteed income payments. Instead, the yields relate directly to the investments involved.

A variable annuity is ideal for people with some insight into the investment world and who relish the possibility of receiving greater rewards if they take some risks.

Fixed Indexed Annuities

Fixed-indexed annuities offer the best of both fixed and indexed annuity contracts. As with fixed annuity contracts, you can rest assured that the interest rate won’t fall below a certain threshold. The minimum interest rate is guaranteed.

However, unlike fixed annuity contracts, fixed-indexed annuities offer some flexibility. For instance, they offer a guaranteed income as with fixed annuities, but they keep the potential for market-linked growth, as is the case with an indexed annuity.

The growth percentile probably won’t be as pronounced as in the case of indexed annuity offers but will still be an improvement on the standard fixed annuity offer. That makes this plan ideal for individuals who seek the potential for growth but still relish stability.

Indexed Annuity Withdrawals

Depending on the choice you make when you sign up for your policy, the payments will have different timeframes. This is true for indexed, fixed, and variable annuities.

When you have a deferred annuity, the insurance company credits money to your account after a certain agreed-upon timeframe. Immediate annuities start paying out as soon as a month after you make the investment.

Remember that early withdrawals on a deferred policy will lead to additional costs.

Indexed Annuity Costs

Like variable annuities and others, there are certain fees related to equity-indexed annuities and other indexed policies. Let’s take a closer look at some of the related costs:

Return Limits – As mentioned earlier on, your life insurance or other issuing insurance company will generally place a cap on the interest rate you can receive through your annuity. They may also limit the percentage of a market improvement that you can benefit from. Both of these might be considered fees since the insurance company will keep any profit earned beyond that margin.
Mortality and Expense (M&E) Fees – Generally, your financial services provider will charge a fee for the future income which they guarantee. Your service agent’s commission may also fall under this category.
Administration Fees – Most service providers will charge you monthly fees for handling the administration linked to your policy.
Fees for Extras (Rider Fees) – If you decide that you’d like to take advantage of some of the optional extras provided by the insurer, you’ll need to pay for each extra attribute you add. For instance, if you want a guarantee that your future monthly income will be at least a certain amount, you’ll need to pay for that service.
Surrender Charges – If you decide to withdraw a part, or all, of your policy before it reaches maturity, then you’ll need to pay a surrender fee. The surrender fee decreases in size as the age of the policy increases. However, while the surrender fees are in place, they can take a significant portion of the invested sum (around 7% or possibly more).

Conclusion

Fixed annuities and fixed-indexed annuities have many fantastic traits and give you a way to earn more from your future retirement income without paying more. If you’d like to benefit from market-linked growth while still maintaining the safety of a fixed annuity, then this is definitely the ideal option for you.

It’s never too early to plan for the future, and having a guaranteed source of income during your golden years is a worthwhile aspiration. If you’re not 100% sure which of the different annuities is best for you, or if annuities are for you at all, try our annuity quiz.

Or, if you’re just trying to understand how much you could earn from your annuity investment, have a look at our retirement income calculator. It will help you calculate precisely what your annuity will pay out at the end of its term. It may also help you choose an annuity by giving you accurate calculations.