If you’re looking for safer financial instruments than the stock market, a fixed index annuity may be of interest. Fixed index annuities allow you to keep hard-earned money protected while enjoying tax-deferred growth for your money based on an underlying index benchmark.
Via a fixed index annuity, you’ll have the ability to take advantage of index-linked growth. You can enjoy some growth potential for your money, balance protection with the risk of other (and more volatile) assets like stocks, and prepare for a financially confident future.
What is a Fixed Index Annuity?
Like other annuities, a fixed index annuity is an insurance contract you own. It’s a fixed annuity which earns interest or provides benefits linked to the performance of an equity index. Examples of indices are the S&P 500®, the NASDAQ®, or the Dow Jones Industrial®. To be clear, fixed index annuities do not directly participate in any financial markets.
The value of the index may be tied to a stock index or another index. When the index records positive change, interest is credited to your annuity’s value. This interest rate is calculated using a formula based on linked index changes. It also comes with a minimum guaranteed interest rate so your principal stays protected in the event of negative index changes.
How Does a Fixed Index Annuity Work?
To recap, a fixed index annuity is a contract between you and an insurance company. You pay premiums and the issuer promises to make periodic payments to you in the future. Premium payments can be made in one lump-sum or in installments over time.
A fixed index annuity is different from other fixed annuity contracts because of the way it credits interest to your annuity’s value. Some fixed annuities only credit interest calculated at a rate set in the contract.
Fixed index annuities credit interest using a formula based on the linked index’s performance. The formula decides how the additional interest, if any, is calculated and credited; how much additional interest you get and when you get it depends on the features of your particular annuity.
The fixed index annuity, like other fixed annuities, also promises to pay a minimum interest rate. The rate that will be applied will not be less than this minimum guaranteed rate, even if the index-linked interest rate is lower.
The value of your annuity also will not drop below a guaranteed minimum. The minimum guaranteed value is the minimum amount available at the end of the term.
Fixed Index Annuity Contract Features
Indexing method – Method used to measure the amount of index change. These methods include: annual reset (ratcheting), high watermark, high water with look-back, short-term point-to-point, long-term point-to-point, monthly average, daily average, and monthly cap.
Participation rate – The rate which decides the percentage of an increase in an index used to calculate index-linked interest. Say the index change is 10% and the participation rate is 70%. Thus the credited interest rate for your money would be 7% (0.1 x 0.7 = 0.07).
Cap – An upper limit, or cap, preset on the index-linked interest rate. This is the maximum rate of interest the annuity will earn; note not all annuities have a cap rate.
Floor – The minimum index-linked interest rate that you will earn. The most common floor is 0%. It assures that even if the index decreases in value, the credited interest that you earn will be zero and not negative. Not all fixed index annuities have a stated floor, but they all have a guaranteed minimum value.
Asset fees – Also known as the margin or spread, fees are subtracted from the linked index gains. If an index grew 7% and the fees were 1%, the credited interest would be 6%.
Interest compounding – It’s important to know whether your annuity pays a compound or simple interest rate during a term. While you may earn less from an annuity that pays simple interest, it may have other features you want, such as a higher participation rate.
Certain fixed index annuities come with surrender periods, or a specific period when withdrawals come with penalties. Surrender periods often last for 10 years. Moreover, sometimes an average of an index’s value is used instead of the index’s actual value for calculations.
Fixed Index Annuity Benefits
- They offer tax deferred growth
- They don’t have annual contribution limits as long as they are flexible premium FIAs
- There is a guaranteed death benefit for your beneficiaries (estate planning solution, does have certain conditions though)
- There are no penalties for mandatory distributions at age 70.5
- They give you the option of receiving a guaranteed income for life, called annuitization
- Or they may offer a guaranteed income rider benefit (also called a guaranteed minimum income benefit (GMIB)) for life without having to annuitize
- They may avoid probate
Key Fixed Index Annuity Trade-Offs
- Your growth potential for your money will be capped in exchange for protection against index drops
- Variations among different annuity products’ features can make choosing the right FIA challenging
- When withdrawn, earnings are taxed as ordinary income based on your tax bracket at the time of withdrawal
- Withdrawals made prior to age 59.5 are generally subject to a 10% penalty unless certain circumstances apply
Do They Have Fees?
Yes. Not in the same way that a variable annuity or a mutual fund does, but more similar to banking fees. Index annuities have penalties for early withdrawal if you surrender the contract early.
You should match the period with your goals while keeping in mind that annuities are designed to be long-term savings instruments.
If the index increases, you won’t get all of this growth. However, your money still have some growth potential — and historically this is above CDs as well as other fixed-interest instruments.
You also have the continuing benefit of your principal and earned interest money being “locked in” on the anniversary date of your annuity contract. In other words, this money is protected from index losses going forward.
Can I Get Back Less Money Than What Was Put in?
Yes, but unlikely. A couple scenarios might be if you cash in an index annuity before the term expires, or if you take more than the free withdrawal amount (in most cases 10% annually) allows in the contract. Surrender charges are usually deducted from the accumulated value which is the original premium plus any interest credited.
If the charges are more than the accumulated value, you will get back less than you put into the annuity. Depending on your contract, an index annuity may contain a market value adjustment provision, as well.
As stated above, a surrender of the annuity will likely mean surrender charges, but market value adjustment charges may also apply.
Finally, if an index annuity has any rider benefits that come with fees, you may have losses in down-index years. Your annuity will be credited zero percent due to the index losses. However, rider fees paid will surpass the zero-interest credit and can result in a loss in your accumulated value.
Be sure to ask your agent or advisor about these potential scenarios for any contracts you may be considering.
Questions to Ask Before Purchasing Annuity
Like with any insurance product, due diligence is highly advisable before purchasing any annuity. Carefully consider your situation and the choices at your disposal.
No single annuity design may have everything you want, be familiar with the features and trade-offs so you make the best decision. Ask these questions:
- How long is the term?
- What is the minimum guaranteed interest rate?
- What is the participation rate?
- For how long is it guaranteed?
- Is there a minimum participation rate?
- Does the contract have an interest rate cap?
- What is it?
- Does the contract have an interest rate floor?
- What is it?
- Is interest rate averaging used?
- How does it work?
- Is interest compounded during a term?
- Are there any fees in the contract?
- What indexing method is used?
- What are the surrender charges or penalties if I want to end my contract early?
Do you have questions or are you ready for personal guidance? Use our Find a Licensed Advisor section to connect directly with an independent financial professional, and to request a personal strategy session to discuss your needs and goals. And should you have any questions or concerns, call 877.476.9723.
