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What is a Fixed Index Annuity?

Published on: Aug 05 2021
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By Olivia Faucher

Annuities are a financial instrument that include a contract between the annuity owner and the insurer. Within the contract, there are various decisions and specifications that must be made. The varying choices that the annuitant can make result in a wide variety of types of annuities. This article will focus on fixed index annuities and their particular attributes.

What is a Fixed Index Annuity?

A fixed index annuity (also called an indexed annuity) will pay you a guaranteed minimum amount, although a portion of your return is dependent upon the performance of a stock market index, like the S&P 500. You receive the low-risk appeal of having a guaranteed minimum return, but you also have the added opportunity to benefit when the financial markets perform well. 

Fixed index annuities offer more growth potential than a fixed annuity, and they also present less risk (and therefore less potential return) than a variable annuity. People often refer to fixed index annuities as hybrids of fixed and variable annuities because they offer both the fixed minimum interest rate and the potential increased return from strong market performance. 

How Does a Fixed Index Annuity Work?

It is important to understand that, while fixed index annuities are tied to the performance of a specific index, the annuitant will not necessarily obtain the entire benefit from any rise in the index. The amount that the annuitant can benefit from positive changes in the index is limited by either a participation rate or a rate cap. Participation rates and rate caps achieve the same effect but work slightly differently. Participation rates only allow the annuitant to benefit a certain percentage of every increase in the index, whereas rate caps simply set a maximum amount that the annuitant can benefit from index increases. Under an annuity contract with a participation rate, the participation rate is applied to each payout. Alternatively, a contract that includes a rate cap instead of a participation rate only gets hit with the rate cap during years that the index performs exceptionally well. Generally, fixed index annuities will include either a rate cap or a participation rate, but not both. 

For example, if the annuity had an 80% participation rate, and the stock index gained 13%, that would translate to a yield of 10.4% for the annuity owner. If instead the annuity had a rate cap of 8% and the index gained 13%, the annuitant would only yield an 8% increase.

Given a year where the index rises more than the rate cap, the rate of return that the annuity owner receives will simply be equivalent to the rate cap. If the index rises less than the rate cap, the annuitant receives credit for the entire index increase. Given a scenario where the index declines over the course of the year, the annuity’s value is protected from the decline by the minimum guaranteed amount, and there is no extra interest awarded to the annuitant. In other words, in the case of a decline in the index value, the annuity does not also lose value, but rather the annuitant will simply receive the minimum guaranteed interest rate and nothing higher than that. 

Example of a Fixed Index Annuity

Gloria purchased a fixed index annuity and funded her account with $50,000. Her annuity is tied to the S&P 500. Gloria’s contract states that she has a guaranteed minimum interest rate of 5% and a rate cap of 7%. During the first year of her annuity, the S&P 500 gains 9%, and Gloria consequently receives a 7% rate of return, leaving her account value at $53,500 (she does not receive the full 9% increase because of her rate cap). In the second year of her contract, the S&P 500 gains 6.5%, so the entire 6.5% increase is reflected in Gloria’s payouts because it is less than her rate cap of 7%. This leaves her account value at $56,977.50. During the third year of her contract, the S&P 500 only gains 3%, so Gloria receives her minimum guaranteed interest rate of 5%, leaving her annuity value at $59,826.38. 

This is how the annuity will continue to accrue interest for the remainder of the accumulation period before the annuitant begins to receive payouts. Once the payout phase begins, the payouts will keep the account value steady at $50,000. It is important to note that this particular example used a rate cap to limit the annuitant’s yield, but the same effect can also be achieved using a participation rate. 

Advantages of Owning a Fixed Index Annuity:

  • If the stock market underperforms, the annuitant does not lose money. The annuitant’s principle is always protected and will not decline if the index performs poorly
  • The annuitant has the additional opportunity to receive higher payouts if the index performs well. 
  • The added increase in yield from payouts may serve as a hedge against inflation.

Disadvantages of Fixed Index Annuities: 

  • High fees that can be associated with fixed index annuities may reduce your gains. 
  • The annuitant’s gains will not reflect the entire increase in the value of the market due to the contractual caps. 
  • Fixed index annuities are also a more complex financial instrument (than other more straightforward annuities) that the investor may struggle to comprehend. 

The Bottom Line

A fixed index annuity could be a smart buy for someone who wants to invest and have growth opportunities without bearing the full risk presented by the stock market. Nonetheless, it is crucial for an annuitant to fully understand all facets of a fixed index annuity before making this kind of investment. 

Special thanks in preparing this summary of “What is a Fixed Index Annuity?” goes to Bob Carlson, leader of the Retirement Watch advisory service and chairman of the Board of Trustees of Virginia’s Fairfax County Employees’ Retirement System with more than $4 billion in assets.

 

 

 

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