How Does an Indexed Annuity Differ from a Fixed Annuity?

how does an index annuity differ from a fixed annuity

There are many different types of annuities available in the financial marketplace today. Two of the more popular types of annuities are fixed annuities and indexed annuities. Indexed annuities are also known as fixed index annuities nowadays.

Both kinds of annuities can have their place in a retirement financial plan. But there are key differences between a fixed and an indexed annuity that people should understand in order to make an informed decision when choosing which type to use.

Before we delve into the differences between fixed and indexed annuities, it’s good to know the ways in which they are similar.

How Are Indexed Annuities and Fixed Annuities the Same?

Money grow tax-deferred inside fixed annuities and indexed annuities, regardless of whether they are housed inside an IRA or a qualified retirement plan.

There is no limit on the amount of money that may be placed inside either type of annuity. Nevertheless, most insurance carriers impose high limits on the amount of money that may be placed inside a single contract.

Both types of annuities also guarantee the return of the policyholder’s principal. Fixed and indexed annuities can also provide guaranteed lifetime income.

You can withdraw some money from a fixed annuity or an indexed annuity if you need it. But if money is taken out before you are age 59.5, you may face a 10% early withdrawal penalty on top of the income taxes due.

And if it’s over a certain amount permitted by the annuity’s provisions for liquidity, there may be a penalty of sorts, too. After all, annuities are designed to be a long-term-commitment vehicle for accumulation of money for retirement and then giving you a guaranteed income stream on the backend.

When you put money into a fixed or indexed annuity, the vast majority of your premium money is put in a conservative portfolio of fixed-income vehicles. Why? So the insurance company can make good on its guaranteed promises to you, the policyholder.

Most of these underlying investments are in Treasury securities, high-quality corporate bonds, and other fixed-interest assets with a low risk profile.

How Are Fixed Annuities Different?

Fixed annuities are by far the oldest type of commercially available annuity. They have been around in one form or another in the United States since 1759, when they were made available to Presbyterian pastors and their families.

Fixed annuities today are similar to bank CDs, except that they are backed by the cash reserves of the issuing insurance company instead of the FDIC. Fixed annuities typically also pay slightly higher rates of interest than CDs, Treasury securities, or savings bonds.

They will pay interest for a set period of time. Some contracts, known as multi-year guarantee annuities, will give you a guaranteed rate for a long time, such as 5 to 7 years. Then they roll over and their interest rates are reset for another term. 

While fixed annuities aren’t backed by the full faith and credit of the U.S. government, the issuing insurance company is required to have at least one dollar in its cash reserves for every dollar of outstanding fixed annuity premium.

They don’t have the power to levy taxes or print money, but it really doesn't matter because they already have the money in their reserves. Many insurance companies go beyond this, maintaining a dollar-and-some-cents in reserves for every dollar of annuity premium.

This is true even for low-rated insurance carriers. Thus fixed annuities can generally be considered to be as safe as other types of guaranteed instruments in most cases.

How Are Indexed Annuities Different?

Indexed annuities are the newer type of annuity available today. They were first introduced in 1992 as a higher-paying alternative to CDs and fixed annuities.

They also come with a principal guarantee, but they don’t pay a fixed rate of interest in the same manner as fixed annuities.

The interest earned by an indexed annuity is based on the movements of an underlying financial benchmark to which the annuity is linked. In most cases, the benchmark is one of the major financial indexes, such as the Standard & Poor's 500 price index.

Indexed annuities tend to be more complex than fixed annuities, which simply pay a straight guaranteed rate of interest. Indexed annuities usually come with a variety of choices for the policyholder to make when they purchase the contract.

Many indexed annuities will credit the contract with interest on a monthly, quarterly, semiannual, annual, or biannual basis. In most cases, the longer the crediting period, the more interest that is earned.

This is because the insurance company can invest the premiums in higher-paying fixed-interest instruments with longer maturities.

How Do Indexed Annuities Earn Interest?

Note that in an indexed annuity, your money is never directly invested in the market. Nor are dividends included in the interest earnings, as indexed annuities aren’t an investment. This is because indexed annuities are fixed insurance products.

The calculation of how your money earns interest is simply based on the underlying benchmark. If the benchmark index goes up, your money earns interest that is based on a portion of that growth. And if the benchmark index is negative in a certain period, your money is simply credited zero percent.

Your principal and interest earnings are “locked in.” This is why we say that the interest rate which an indexed annuity pays isn’t guaranteed like a fixed annuity does.

As an exchange for this protection of principal and interest earnings in negative index periods, the insurance company has some controls on the growth potential of your money inside an indexed annuity.

It will use caps, participation rates, or spreads to limit the ceiling of how much interest your money might earn. This is still a good trade-off for the protection benefit.

In return for receiving a non-guaranteed rate of interest, most indexed annuities will pay more interest over time than their fixed annuity cousins.

When the benchmark declines in value, then the annuity will either pay nothing or a low guaranteed rate of interest.

But the annuity owner must put a portion of their premiums into a fixed bucket in order to receive this. The fixed-interest bucket is one option among other interest-crediting options on a monthly to annual or biannual basis, as mentioned above.

How Does the Insurance Company Do This?

How does the insurance company give you this growth potential in an indexed annuity, you might ask?

The insurance carrier will put 3 to 5 cents of every dollar in indexed annuity premium in call options that rise in value when the benchmark rises. The rest goes into the underlying fixed-interest assets in the same manner as with fixed annuities.

Another Benefit of Indexed Annuities

Most indexed annuity contracts also offer several types of riders that can guarantee a minimum stream of income or death benefit. The advantage that many of these riders offer is that they can be turned on and off as needed (certain conditions do apply).

The latest type of guaranteed income rider can guarantee income for life without tying up all of the principal in the contract.

Some indexed annuities also calculate their income payouts based on a hypothetical benefit base that is larger than the actual cash value in the contract.

How Do the Limits on an Indexed Annuity’s Growth Work?

What about those limits on the growth opportunity for your money? In exchange for their higher growth potential, indexed annuity contracts are limited in the amount of interest that they can credit in any given period.

There are basically three ways that this limitation can be imposed. Some contracts have a cap on the amount of interest that can be credited, such as 10% per year.

Other contracts will only pay a fraction of the benchmark's performance, such as 70%. This is known as a participation rate. But many indexed annuity contracts don’t have a limit on the amount that 70% can be.

Another type of limitation is known as a spread, where the insurance carrier will keep a certain amount of the benchmark’s increase before crediting the contract with interest.

For example, if the benchmark rises by 8%, then the insurance company may keep the first 2% of the growth and credit the remaining 6% to the contract.

Keep in mind that insurance companies can adjust these controls depending on changing economic conditions. For example, low interest rates may pose interest rate risk to the insurance company's holdings and affect their ability to earn higher interest.

The insurer may have to adjust rates accordingly, but your indexed annuity should still have the ability to earn interest above a CD or other fixed-interest options.

Exploring Fixed Annuities and Indexed Annuities for Your Retirement

Fixed and indexed annuities are similar in many ways but are also different in some important respects. They are a few of many annuity kinds available for different needs and situations. Consult your financial advisor for more information on these types of annuities and find out whether one of them is right for you.

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