A fixed index annuity is an insurance contract that provides you with income in retirement. With a fixed index annuity, your payments are based on the returns of a stock market index, like the S&P 500 or the Dow Jones Industrial Average. Unlike directly investing in the stock market, you’re generally protected against losses—in exchange, your total returns will be limited, and your contract may charge additional fees.
How Does a Fixed Index Annuity Work?
A fixed index annuity provides steady payments that are based on the performance of an underlying index. Fixed index annuities offer some of the upside of investing in index funds, and may track the S&P 500, the Nasdaq, the Russell 2000 or the Hang Seng. Unlike index funds, fixed index annuities are generally protected against loss of principal. This means you won’t lose any of the money you put into a fixed index annuity.
This protection against losses, however, comes at a cost. You won’t receive the exact return of the market index. Instead, the annuity will limit both your potential gains and your losses. This system makes an indexed annuity safer than investing directly in the market, though investing in a fixed annuity is more complicated than investing in an index fund.
How to Invest in a Fixed Index Annuity
To set up a fixed index annuity, you first need to buy the contract. You can make a lump sum deposit, transfer over funds from a retirement plan or make multiple payments over time. You then tell the annuity company how it should invest the money.
You can put your money all in one index or divide it across several. Your returns are based on how the market indexes you choose perform.
Fixed Index Annuity Returns
A fixed index annuity will most likely limit your annual gains as well as your annual losses. Some of the common components for limiting gains or losses include:
- Loss floor. A fixed index annuity may limit your losses, even in a bad year for the market. It’s common for the floor to be 0%, so worst case you just break even in a downturn.
- Minimum return. A fixed index annuity might pay a small guaranteed interest rate or return, so no matter how the market index performs you earn at least some money.
- Adjusted value. Your fixed index annuity could use an adjusted value method to protect against losses. This means the annuity company would periodically adjust the minimum value of your contract based on the returns you’ve already earned. This locks in your gains so you can no longer fall below this threshold.
- Return cap. Your annuity company could also set a limit to your gains. For example, it might say that no matter how high the index return, the most your balance could grow in a good year is 5%.
- Participation rate. Your annuity company may choose to limit your gains through a participation rate. The participation rate is the percentage of your money that’s actually eligible to earn market returns. For example, if the participation rate is 50%, you would receive half of the index’s returns. If the market index return is 8%, your balance would only grow by 4%.
- Spread/margin/asset fee. Your annuity company could also deduct a spread/margin/asset fee from your return each year. If their fee is 3% and your return is 8%, your money would only grow by 5%.
A fixed index annuity contract might tack on one or more of these features. Be sure to closely study a contract to see exactly how your gains and losses will be limited.
Fixed Index Annuity Withdrawals
When you’re ready to start taking money out, you can convert your fixed index annuity balance into a stream of future income. These payments can last for a fixed period of time, like 20 years, or for the rest of your life. The amount you’ll receive depends on your account balance, your investment return and how long you want the payments to last; a longer period means smaller monthly payments.
Alternatively, you could also make a lump sum withdrawal or take all your money out at once, but this has some downsides. Annuities typically have a surrender period that lasts between five to seven years after you bought the contract.
If you take out a lump sum withdrawal, the annuity company could charge this fee, which is usually around 7% of your withdrawal, though it may decrease each year you hold an annuity. Consider this surrender period before signing up as fixed index annuities are supposed to be long-term contracts. If you’re under 59 ½, you may also be subject to a 10% penalty by the IRS for early withdrawals.
What’s the Difference between a Fixed Index Annuity and an Index Annuity?
An index annuity is the same thing as a fixed index annuity. You may also hear fixed index annuities described as equity indexed annuities. Annuity companies use a few different names for the same product; this just comes down to their branding and personal preference.
Whether you hear the term fixed index annuity, indexed annuity or equity index annuity, know it’s describing the same type of contract: one that is based on market index returns, with limits on your losses and gains.
Fixed Index Annuity Fees
Fixed index annuities do not charge an upfront fee. Instead, the annuity company will deduct its fees from your account balance each year.
Some of the possible charges include:
- Return limits. In years when your market index has a high return, the annuity company keeps a portion, according to the terms of your contract.
- Mortality expenses. Also known as M&E fees, these cover the expected cost for the annuity company for its future income guarantees. It also covers the company’s costs for selling the contract.
- Administration fee. The fixed index annuity may charge an additional administration fee each year.
- Riders. When you sign up for an annuity, you can choose to purchase riders that provide extra benefits for the contract. For example, you could buy one that guarantees a minimum return over the life of the contract. You’ll pay an annual fee for each rider.
- Surrender charge. You’ll owe a fee called a surrender charge if you cancel the contract or make a lump sum withdrawal within the first few years of your fixed index annuity.
Advantages of a Fixed Index Annuity
- Limit on your losses. During big market downturns, you don’t have to worry about large losses with a fixed index annuity.
- Possible guarantees for your earnings. An index annuity could pay a guaranteed minimum return, even when the market index loses money. It may also lock in your earnings over time to protect you from even greater losses.
- Inflation protection. The long-term expected return on a fixed index annuity is higher than other guaranteed accounts, like a fixed annuity or a certificate of deposit (CD). This can help grow your savings more than inflation.
- Tax-deferred growth. An annuity delays taxes on your gains until you take the money out, much like an individual retirement account (IRA) or 401(k). This can help boost your after-tax return over comparable money held in a regular brokerage account. This tax-advantaged status, however, also opens you up to a 10% penalty if you need to withdraw from your annuity before age 59 ½.
Disadvantages of a Fixed Index Annuity
- Limit of potential gains. Fixed index annuities cap your potential upside, so you don’t earn as much in good years as investing directly in the market.
- High fees. Between the annuity fees and the earnings cap, you could end up paying a sizable amount of your gains each year to the annuity company.
- Surrender charges. If you cancel your contract before the surrender period, you could owe a significant fee to the annuity company.
- Some return uncertainty. Even with the loss cap and minimum return features, there is still some uncertainty over how much you’ll earn each year with a fixed index annuity.
Fixed Index Annuity vs Variable Annuity
Like a fixed index annuity, a variable annuity puts your money in stock market funds. But unlike fixed index annuities, variable annuities offer less certainty of returns: You get the full market return, good and bad.
During good years, you can potentially earn more with a variable annuity. But if your investments do poorly, you could lose significantly more with a variable annuity.
That said, you might choose a variable annuity if you want to take on more risk for potentially greater returns. Fixed index annuities may be better for those who want some stock market exposure but don’t want the potential of large losses.
Fixed Index Annuity vs Fixed Annuity
Like a fixed index annuity, a fixed annuity offers some amount of guarantees about your rate of return. But unlike fixed index annuities, fixed annuities do not invest your money in the stock market. Instead, the annuity company pays you a set, guaranteed return each year.
This way you know exactly how much your savings will grow after you sign up for the contract. This may help you with your retirement income planning. The downside is that the long-term fixed return could end up lower than what you’d earn in the market.
A fixed annuity is better if you have a shorter timeline for needing your money and want to be sure your savings grow at least somewhat. A fixed index annuity can be better for longer investments, when you want higher growth and don’t mind some down years along the way.
Should You Get a Fixed Index Annuity?
If you’re investing for the medium- or long-term, and want some market exposure with less risk, the fixed index annuity could be a good compromise. Your long-run potential return is higher than if you kept all your money in a guaranteed account, like a fixed annuity or a CD. At the same time, you don’t have to worry about a steep market loss.
These guarantees do come at a cost so make sure you weigh the tradeoff from the limits on gains and the annuity fees. In addition, these contracts can be complicated to understand. Consider speaking with a financial advisor before signing up for a fixed index annuity.
This article originally appeared on Forbes.
