What is an Indexed Annuity?

An indexed annuity is a type of deferred annuity. It is a contract between an insurer and the annuity owner under which the account of the annuity owner is credited interest based on the performance of a named investment index or a combination of named investment indexes.

Indexed annuities also have been called equity-indexed annuities and fixed-indexed annuities. Unique features of most indexed annuities are that the account usually doesn’t lose value when the indexes decline and there might be a guarantee that a minimum amount of interest will be credited to the account each year.

Definition of an Indexed Annuity

All annuities are contracts between an insurance company, or insurer, and the annuity owner, who might also be known as the insured or the annuitant. An indexed annuity is a deferred annuity because the annuity owner does not receive fixed income payments shortly after the annuity contract is signed. Instead, an account is established for the owner with an initial amount equal to the amount the owner deposited with the insurer.

Each year, interest is credited to the account. The interest is based on the return of an investment index or a combination of investment indexes, also known as a benchmark. The benchmark might be a major stock market index, such as the S&P 500. Or the benchmark might be a combination of indexes that represent different asset classes. For example, a benchmark might be 60% of a major stock market index, 30% of a bond market index, and 10% of a commodity index.

Often, the annuity contract states that the account value won’t decline, even if the benchmark declines by a substantial amount. The annuity contract also is likely to guarantee a minimum interest rate will be credited to the account in a year when the benchmark declines. But in recent years the guaranteed interest rate in most indexed annuities has been 0%.

How Does an Indexed Annuity Work?

The annuity account is not invested in the benchmark. Instead, interest is credited to the account based on the performance of the benchmark. In addition, the account usually is not credited with the full return of the benchmark. The annuity contract has a formula that determines how much interest is credited to the account.

The formula first looks at the performance of the benchmark during the year. Some indexed annuities begin with the year-over-year return of the index. Some consider dividends that might be paid by companies in a stock index, while others look only at the price change in the index. Some indexed annuities don’t use the 12-month return of the benchmark. Instead, the formula might use the average monthly or daily value of the index, the average monthly gain, or some other factor.

An important feature of the formula limits the amount of interest credited to the account. While indexed annuities are tied to the performance of a specific index, the account often is not credited with interest based on the total return of the benchmark.

The indexed annuity is likely to have a participation rate limit or a rate cap, or both. Participation rates and rate caps achieve the same effect but work slightly differently. Participation rates provide that the account will be credited only with a specified percentage of the benchmark’s return (as determined by the formula) for the year. If the participation rate is 60% and the benchmark’s return per the formula is 10%, the crediting formula will use only 6%.

A rate cap puts a ceiling on the amount that can be credited to the account each year. If the rate cap is 10%, no more than 10% interest will be credited to the account in a year, regardless of how well the benchmark does and what the participation rate is.

For example, if the annuity had an 80% participation rate, and the stock index gained 13%, the annuity account is credited with 10.4% interest for the year. If the annuity instead had a 10% rate cap but a 100% participation rate, the account would be credited with only 10% interest. If the account has both an 80% participation rate and a 10% rate cap, the account would be credited with only 10% interest for the year.

Suppose the benchmark declines 10% for the year. Most indexed annuities provide the account won’t lose any value. Instead, the minimum guaranteed interest rate will be credited to the account. Most indexed annuities issued in recent years have a 0% guaranteed interest rate.

Suppose Thomas purchased an indexed annuity and funded his account with $50,000. The benchmark is the S&P 500, and the contract has a 100% participation rate, a 0% minimum interest return and a 7% rate cap. During the first year, the S&P 500 gains 20%. Thomas’s account would receive an interest credit of 7%, giving his account a value of $53,500.

In the second year of his contract, the S&P 500 declines 15%. Thomas’s account doesn’t lose any value. But since the guaranteed interest rate is 0%, it also doesn’t increase. In the third year, the S&P 500 increases 6.5%. The interest rate credit to Thomas’s account is 6.5%, giving his account a value of $56,977.50.

Indexed annuity contracts should be considered by investors who want a higher return than can be earned from certificates of deposit, money market funds, bonds, and other conservative investments. Because they usually have guaranteed minimum returns and protect principal, indexed annuities also are for conservative investors whose primary goal is to protect their investment principal. Because of the participation rates, interest rate caps and the interest-crediting formulas, indexed annuities aren’t for investors who expect to earn the full return of market indexes when investment markets are doing well.

In others words, indexed annuities should be considered by safety-conscious investors who would like an opportunity to earn higher returns than available on conservative investments and who can accept occasional years when 0% interest is credited to their accounts.

Pros of Investing in an Indexed Annuity

Indexed annuities provide the opportunity to earn more interest than is available from conservative investments. They also protect investors from the volatility of the markets and eliminate the risk of market losses. The annuitant’s principle is always protected and will not decline if the index performs poorly. The annuitant has the opportunity to receive higher interest if the benchmark performs well.

Cons of Buying an Indexed Annuity

Indexed annuities tend to have high fees, which are subtracted before interest is credited to your account. In addition, the formulas used to compute the interest credited to the account can be complicated. Some indexed annuity owners receive less interest than they expected based on published returns of market indexes. Owners of indexed annuities need to understand that they won’t receive the full return of their benchmarks most years.

Indexed annuities often lock in investors for a period of years with surrender charges. Usually, if an investor wants the deposit returned or wants to change investments, the insurer will deduct a fee if the minimum holding period hasn’t passed. A standard minimum holding period is seven years, though the holding period can be either shorter or longer. A typical surrender fee provides that if the annuity owner wants to exit the annuity before a year has passed, a surrender fee of 7% will be charged. The surrender fee is reduced by one percentage point each subsequent year until there is no surrender fee once the annuity has been held for at least seven years.

The Bottom Line

An indexed annuity can be appropriate for someone who wants the opportunity to earn more than is available from conservative income investments but doesn’t want to take the risk of a decline in the value of investment principal. The investor should be able to hold the annuity at least until the surrender fee period has passed and must be willing to accept years when little or no interest is credited to the account.

Indexed annuities are essentially a hybrid between fixed and variable annuities, providing the safety of guaranteed minimum returns in addition to offering the potential to higher interest credits based on the performance of the benchmark.

What you don’t know about your retirement finances can hurt you. Learn more about all aspects of your retirement finances, especially the most important recent changes, through Retirement Watch. The only publication to cover all the elements of retirement finance, it has been edited for more than 30 years by America’s #1 retirement expert, Bob Carlson. Carlson was trained as an attorney and accountant and has served as Chairman of the Board of Trustees of the Fairfax County Employees’ Retirement System (which has more than $5 billion in assets) since 1995.