How Indexed Annuities Work

Indexed annuities promise principal protection and potential investment growth. However, the investment product doesn’t consistently deliver regardless of its popularity. This is why it is crucial to know exactly what you are buying before splurging.

Learn more about how indexed annuities work and the steps to invest today. 

What is an Indexed Annuity?

An indexed annuity is a contract that is issued and guaranteed by an insurance company. The insured typically invests a certain amount of money or premium in protecting against any negative returns in the U.S. equity market. The U.S. equity market emphasizes the potential for some investment growth by being linked to an index.

Annuities are only as good as an insurance company’s ability to honor the commitment. Indexed annuities are not considered securities and are not regulated by the U.S. Securities and Exchange Commission (SEC) or the Financial Industry Regulatory Authority (FINRA). 

They are regulated by state insurance departments, and individual insurance companies can reduce the insured’s upside by imposing caps, participation rates and spreads for guarantees.

Benefits of Indexed Annuities

Similar to any investment, index annuities have pros and cons. Because they are generally a hybrid of fixed and variable annuities, there is a mixture of both advantages and disadvantages. 

There is the chance to receive higher returns minus the risk of losing money. Annuities are relatively complex to understand, so below is a list of the pros and cons of using index annuities.

•  Some fixed income: You will get some fixed income
•  Hedge against market losses: The indexed annuity hedges against market loses
•  Gain value from index growth: Index growth can add more value to your annuity
•  State-regulated: You’re not buying a cheap investment.
•  Tax-deferred:  All annuity types, like indexed annuities, are tax-deferred products
•  Increases with stock: Whenever a stock increases in value, the value of the contract 
  also increases
•  Doesn’t decrease with stock: Should the stock underperform, you don’t lose money
•  Protects against inflation: Added increase in yields serve as a hedge against inflation

Some of the cons of an indexed annuity include the following:

• Gains capped: Gains of the contract will be capped and won’t necessarily reflect the entire increase in the value of stocks
• Lack of fee transparency: Sometimes fees are not disclosed
• High sales commissions: Expect to pay commission when you purchase
• Cap can be reduced: The cap in increasing value can potentially be reduced in the later years of the contract, and the percentage of the gain you receive in the index value may decrease
• Penalty for early withdrawal: With other annuities, you face high surrender charges for early withdrawal

There is a difference between indexed annuities and fixed and variable contracts. Indexed annuities only make up one-third of the leading annuity types. The types are fixed annuities and variable annuities.

Fixed annuities are not tied to the stock market’s performance. Interest rates set in the contract at the time of purchase do not fluctuate. Funds are guaranteed to grow at the same rate for a certain period.

Under variable annuities, interest rates change according to the performance of an investment portfolio. However, variables don’t include the same limits on losses as index annuities. Though the investments you choose for your variable annuity decline, the value of your annuity will also see a decline. Since interest rates are tied to market performance, indexed annuities put you at more risk but with greater potential returns than a fixed annuity.

The guaranteed minimum return of an indexed annuity is much less risky than a variable annuity while offering potentially lower returns.

• The perfect mix of fixed and variable: Indexed annuities are an ideal mix for people who want a negligible risk but not too much
• Just as easy to apply and pay: All annuities are easy to buy into and pay for. That’s not complex.
• Fewer market benefits: Because indexed annuities are split between the two, you don’t gain as much when the market soars

Let’s take a deep look into indexed annuities by answering some common questions.

How Much Do Indexed Annuities Cost?

Indexed annuities usually do not have an upfront charge, but there tend to be large surrender fees. Surrender fees are what you pay if you need access to your money before the surrender period ends and other hidden costs.

With indexed annuities, there are many opportunity costs passed down to customers by the insurance company. This is done by limiting potential returns through a participation rate, cap, or spread. 

Consulting with an agent to better grasp how the product works will work to your advantage. That way, you will know upfront what factors can slow down your potential return.

Can you lose money?

The short answer is yes. You can lose money if the market index associated with your annuity goes down and you receive little to no minimal index-linked return. When this happens you can lose money on any potential investment by withdrawing assets before the surrender period is over.

The principal is protected only by holding the annuity through the surrender period. For example, this time frame could be anywhere from 10 years or longer. 

Unfortunately, there are a lot of investors who believe that regardless of what happens to the market, they will still get their money back. In reality, this is not always true.

Who should get indexed annuities?

Indexed annuities are a perfect fit for someone nearing retirement and, at the same time, looking for a way to generate guaranteed income that supplements Social Security checks.

With this type of annuity, customers are offered much lower fees than variable annuities with favorable yearly returns. Indexed annuities are designed to return anywhere between three and seven percent net. 

There have been cases in which returns are much higher than that on average. Sometimes it reaches six to 10 percent.

Are Indexed Annuities Right For You?

Indexed annuities can be a challenging concept to understand. It’s important to speak with a professional to understand the process and know it might be in your best interest to seek a different type of annuity or combination of investment products.

Frequently Asked Questions