What Is a Fixed Indexed Annuity? 

An indexed annuity is a type of annuity contract that pays an interest rate based on the performance of a specified market index, such as the S&P500 or Suisse Credit. It differs from fixed annuities, which pay a fixed rate of interest, and variable annuities, which pays their interest rate on the performance of a portfolio of securities chosen by the annuity owner. Indexed annuities are sometimes referred to as equity-indexed or fixed indexed annuities. Fixed and variable annuities are not discussed in this article. Fixed Indexed Annuities will be referred to as FIA from here forward. 

How Indexed Annuities Work

FIAs offer their owners, also called annuitants, the opportunity to earn higher yields than fixed annuities when the financial markets perform well. Typically, they also provide protection against market declines. 

The rate on an indexed annuity is calculated based on the year over year gain in the index or by its average monthly gain over a 12-month time period. 

While FIAs are linked to the performance of a specific market index, the annuitant could only benefit partially from any rise in that index. One reason is that FIAs often set limits on the potential gains at certain percentages, this is commonly referred to as the “participation rate.” The participation rate can be as high as 100%, meaning the account is credited with all of the gain, or as low as 25%. Most FIAs offer a participation rate between 80% and 90% usually in the early years of the contract. If the stock index gained 15%, for example, an 80% participation rate would yield a credit of 12%. Many FIAs offer a high participation rate in the first year or two, after which the rate adjusts downward. 

Yields and Rate Caps 

Most FIA contracts will also include a rate cap that can further restrict the amount of credited interest to the accumulation account. For example, a 7% rate cap, limits the credited yield to 7% no matter how much the market index has gained. Rate caps can be as high as 15% or as low as 4% and are subject to change. 

In the example above, the 15% gain reduced by an 80% participation rate to 12% would be reduced further to 7% if the annuity contract specifies a 7% rate cap. 

During the years of a stock index decline, the insurance company credits a minimum rate of return. A typical minimum rate guarantee is usually between 0%-3%. This percentage is commonly referred to as a floor.  

This floor is what allows the annuitant the ability to keep the equity in the account, compared to a 401K or traditional IRA values that would be affected in any market downturn. 

Adjusted Value Period 

At specified intervals, the insurance company will adjust the value of the FIA account to include all gains that occurred in that time frame. The principal, which the insurer guarantees, never declines in value unless the owner takes an early withdrawal. Insurers use several different methods to adjust the account’s value, such as a year-over-year reset or a point-to-point reset, which incorporates two or more years’ worth of returns. 

As with other types of annuities, the owner can begin receiving regular income by annuitizing the contract and directing the insurer to start the payout phase. 

Early Withdrawal Penalties 

Withdrawing money from an annuity can result in penalties, including a 10 percent IRS penalty for taking funds from your annuity before age 59 ½. 

Because annuities are designed for the specific purpose of providing retirement income, the IRS and insurance companies have implemented financial penalties to deter annuity owners from making withdrawals beyond what the contract allows. 

It’s crucial to consider the consequences from the federal government as well as from the issuing insurance company before you withdraw money from your annuity. If the consequences outweigh the benefits, you may want to consider selling a portion of your annuity payments instead. 

  • You may face a penalty or a surrender fee, also known as a withdrawal, or surrender charge if you take money out of an annuity. 
  • In addition to potential surrender fees, the IRS also charges a 10 percent early withdrawal penalty tax if the annuity-holder is under the age of 59 ½. 
  • The time it takes to receive money from an annuity often depends on the company you are dealing with. The typical timeframe for receiving cash from an annuity is four weeks. 

It can’t be stressed enough to read the contract in full. Learn when and how much withdrawals can be made at the beginning. 

Immediate or deferred? 

Like the fixed and variable annuities, FIAs offer annuities that are immediate or deferred. 

Immediate annuities payout starting the 13th month after a lump sum investment. This type of annuity is good for seniors of advanced age. They don’t have to wait a long time to start receiving they’re income. 

Deferred annuities start payout after the time period outlined in the contract. This period is the growth period. For an example, payment starts after a 10-year deferment. This type of annuity can be used for either income, or accumulation. Ethically, this type of annuity should be reserved for individuals that are just retiring. 

Accumulation or Income? 

Income annuities are designed to provide guaranteed income, rather than to help accumulate a retirement savings. Immediate income annuities guarantee income that begins within 13 months of contract issue in exchange for a single purchase payment. 

Accumulation annuities are for accumulation for retirement. Cash can be periodically withdrawn after the deferment period. This type of annuity will not give a steady monthly or yearly income, but rather builds the account up. 

Qualified vs non-Qualified 

FIAs are like the other annuity types, they are either taxed 100% or partially taxed at annuitization. The money used to fund the account must be specified of which type it is at the beginning. Below are the differences. 

Qualified means that the funds being used to fund the annuity, are from a “qualified” fund such as a traditional IRA or 401K. These are pre-taxed monies that will be taxed the same way the contributing fund would have been. With this type, 100% both gains and principle will be taxed when annuitization begins. 

Non-Qualified means the money used to fund the annuity has already been taxed or “non-qualified“, such as money from a savings account or a Roth IRA. With this type, only the gains are taxed when annuitization begins. The principle has already been taxed. 

Are there any Advantages? 

The biggest advantage to a FIA, is the fact that the owner will not lose any money during any market downturn. Leaving a large sum of money in a traditional IRA or 401K or other employer sponsored retirement account after the age of 59 ½, is the equivalent to taking your entire retirement to a Las Vegas casino, and gambling it away. Maybe you will hit, maybe you won’t. This is no longer the time to take risks with your money as you did during your employment years. With a FIA, gains are guaranteed during market upswings, but the floor rate guarantees that value losses of the annuity won’t happen either, as outlined above. Several years of a down market would take away value from an IRA or 401K leaving very little to live on. 

Is it Time to Calculate Your Retirement Date?  

If you are 59 ½ or older, and retirement is upon you, it is time to consider investing in a FIA. A financial advisor, or someone that deals with FIAs can guide you to what makes sense for you. Annuities are very regulated now, so be prepared to have accessible cash on hand for emergencies. Factor in 9 months’ worth of debt as emergency accessible cash. This is above the annuity investment amount. The Insurance company will want a financial statement from the proposed annuity owner also.