What are fixed index annuities? Benefits, risks and how they work

Many people worry about investing in the stock market as they near retirement. The markets are inherently risky, which can be hard to stomach when you’re preparing to permanently leave your job and live off your savings. 

Fixed index annuities are one way to potentially participate in market gains while protecting against market downturns. 

It sounds alluring, especially for soon-to-be retirees looking for a safe, reliable source of income to supplement their Social Security or pension. But these complex financial products come with a lot of strings attached. 

Before jumping in, it’s important to understand all the rules, restrictions and fees associated with fixed index annuities to make sure it’s the right move for your financial goals.

What are fixed index annuities?

A fixed index annuity is a contract between you and a life insurance company. Like all annuities, you agree to make a lump sum deposit or a series of payments to the insurer, and in exchange, the insurance company promises to return your principal back to you — along with some interest — for the rest of your retirement, or however long you choose. 

Fixed index annuities specifically earn an interest rate linked to a stock market index, such as the S&P 500, while also offering principal protection from negative returns.  

Unlike traditional fixed annuities, which grow based on a set interest rate in your contract, index annuities tie some or all of their interest rate to the performance of an underlying stock market index. 

If the index has a strong year, you’ll receive some interest added to your annuity’s contract value. If the index has a negative year, there is no index interest added, but your annuity contract does not lose value. 

Some fixed index annuities also offer a guaranteed minimum interest rate, which usually ranges from 1 to 3 percent, according to the Financial Industry Regulatory Authority.

To clarify, fixed index annuities and index annuities are the same thing. They’re also sometimes referred to as equity indexed annuities. Annuity companies often use different names to describe the same product — in this case, an annuity contract based on market index returns, with limits on your losses and gains.

Fixed index annuities tend to be most suitable for long-term conservative investors looking for a little market lift without the market risk.

Limits on the rate of return

If you’ve been waiting for a catch, here it is: While fixed index annuities offer a chance to participate in the market’s upside potential without risking your principal, they limit your returns. 

In other words, you pay a price for all that safety. Fixed index annuities act like guardrails, protecting you from stock market nosedives but also capping how much your money can earn. 

Insurance companies employ one or more of the following to limit a fixed index annuity’s rate of return:

• Participation rates: This determines what percentage of the index’s growth you actually receive. For example, if the index increases 10 percent in a year and you have a 50 percent participation rate, your annuity contract will get credited with 50 percent of the gain, or 5 percent. 
• Interest caps: To mitigate risk, insurance companies often impose caps on the maximum interest rate that can be credited to your account, regardless of how much the underlying index gains in any given year.
• Spreads: The spread is a charge applied after the participation rate is calculated. It’s a percentage subtracted from the index return, and usually averages around 2 percent.  

Participation rates and spreads work together to reduce the potential upside of a fixed index annuity. If the S&P 500 nets a 10 percent return at the end of the year, and your 50 percent participation rate reduces your gain to 5 percent, then a 2 percent spread will reduce it even further to 3 percent. 

It’s important to keep in mind that insurance companies can change the factors used to calculate your rate of return at any time during the life of your annuity contract. 

Fixed index annuity withdrawals

Like other types of annuities, fixed index annuities impose restrictions on withdrawals. Account holders can only take out small amounts of money each year, usually up to 10 percent, or else face penalties and fees. 

There’s a surrender charge period that dictates the penalty for withdrawing money early. The earlier in the term you withdraw, the bigger the penalty. The penalty amount typically reduces as the term progresses, and usually drops off completely after eight to 10 years. 

However, even after your surrender period ends, you may still get penalized by the insurance company for withdrawing more than 10 percent of your annuity’s contract value in any given year. 

The rationale behind these penalties, according to insurers, is to discourage people from tapping annuity funds before retirement. But the IRS already imposes a fee for this exact reason. 

If you withdraw money from an annuity prior to age 59 ½, you’ll get hit with a 10 percent fee from the IRS — on top of whatever the insurance company charges you. The withdrawal is also subject to income tax. 

Annuity contracts typically include a 10 to 30 day “free look period,” during which investors can cancel the contract without penalties.

Fixed index annuity fees

Fixed index annuities typically don’t charge an upfront fee. However, you’ll pay an annual fee along with any fees on riders. 

• Annual fee: Annual fees are usually deducted from your annuity contract value. Insurance companies deduct these fees to cover administrative and management expenses.
• Riders: Riders are optional benefits or features added to your annuity contract at a cost, such as a death benefit paid to your heirs. 

And don’t forget, the insurance company profits by limiting your returns through participation rates, caps and spreads, which can impact the overall growth potential of your fixed index annuity. The specific amounts of all fees are disclosed in your annuity contract. 

Benefits of fixed index annuities

Fixed index annuities offer some benefits for people looking to prioritize security and guaranteed income in retirement. 

• Principal protection: This is the primary draw of fixed index annuities. Your principal investment remains safe regardless of market downturns.
• Tax-deferred growth: Earnings within the annuity grow tax-deferred, meaning you don’t pay income taxes on earnings until you begin receiving payments from the insurance company or make a withdrawal.
• Guaranteed lifetime income: Annuities, including fixed index annuities, offer a reliable source of income during retirement without the hassle of managing your own portfolio or the risk of outliving your savings. 

Drawbacks of fixed index annuities

Some investors are attracted to fixed index annuities because they think these products offer the same level of market participation as buying an index fund. However, the reality is that fixed index annuities come with restrictions that all buyers should be aware of before signing a contract. 

• Limited growth potential: While fixed index annuities provide downside protection, the imposed caps and fees limit the extent of potential gains, especially during periods of robust market performance. You’d enjoy greater potential returns by directly investing in a low-cost index fund.
• Complexity: Fixed index annuities are notorious for their complexity. The various terms, conditions and fees associated with these products can make it difficult for the average person to understand the terms of their contract and figure out how much money they might earn.
• Fees and expenses: Ongoing annual fees, withdrawal penalties and surrender charges can eat into your returns.
• Limited liquidity: It can be difficult — and costly — to get money out of an annuity, especially once you begin receiving payments from the insurer. This can limit your flexibility if you have unexpected expenses in retirement.

How to buy a fixed index annuity 

If you’re interested in purchasing a fixed index annuity, the first step is to research these products and understand how they work, their features, benefits and drawbacks. This article is a great starting point, but additional research is recommended. You might consider speaking with a financial advisor who can provide personalized guidance based on your financial goals and risk tolerance.

Next, choose a reputable insurance company that offers fixed index annuities. Look for insurers with strong financial ratings and a track record of reliability. 

Carefully read an annuity contract before you sign it. Pay close attention to the details, including surrender charges, fees, participation rates, interest caps and any attached riders. Getting an independent financial advisor who isn’t associated with the insurance company to review the contract before you sign can also be a smart idea. 

Deciding if a fixed index annuity is a good fit for you depends on a few things, including how much risk you’re willing to take with your money and your goals for retirement. They might be a good choice for some people, but not for everyone.

Bottom line 

Fixed index annuities offer a unique blend of security and potential growth. They can be a viable option for risk-averse investors seeking guaranteed income in retirement. However, their limitations — including capped returns, fees and reduced liquidity — must be carefully considered. By thoroughly understanding how they work, you can make an informed decision about whether a fixed index annuity is the right fit for your retirement plan.