What is a Fixed Index Annuity and How Does it Work?

A fixed index annuity might be the perfect fit for you if what you’re most looking for is principal protection. Here’s everything you need to know about this common insurance product.

What is a Fixed Index Annuity?

A fixed index annuity is unique in that it offers some market growth while carrying less risk. It’s kind of a cross between variable and fixed annuities. Some of your return is dependent on the performance of a market index (like the S&P 500), but it also comes with a guaranteed minimum payout. Any interest earned accumulates on a tax-deferred basis until you take money out.

How Does a Fixed Index Annuity Work?

A fixed index annuity has a guaranteed minimum payment which is determined by the interest rate floor (or the minimum interest rate) set by the insurance company. Regardless of how the market performs, the interest rate floor must be honored. In other words, a 0% interest rate floor means your principal is protected, even if the insurance company’s investments falter. This is an obvious upside to this type of product.

On the flip side, something a little less attractive is that with reduced risks comes less potential for high returns. Why? Most insurance companies will cap your gains to protect themselves from losses.

Though every contract is different, here is how a fixed index annuity generally works:

• Once you purchase the contract and begin paying into your fixed index annuity, the insurance company will invest your money into the market index that you’ve chosen. The most common indexes this type of annuity will follow tend to be the S&P 500, the Nasdaq 100, and the Russell 2000.
• Your “participation rate” will determine how much of the index’s benefits can be gained by your annuity. The participation rate is the percent of gains you agree to take if the stocks go up (companies will usually offer high rates at the beginning of your contract, but lower as time goes on). Here’s an example from Investopedia: if your stock index gained 15%, an 80% participation rate translates to a credited yield of 12%.
• Your guaranteed minimum return ensures that you receive at least a certain amount. For example, if your minimum return is 2%, but the index is down, your annuity will still earn that promised 2%.

Who Should Consider a Fixed Index Annuity?

There are a lot of factors that can go into making this decision. You and your financial advisor should consider potential goals and what kind of riders make sense for you (optional enhancements to your contract at an additional cost). Usually, someone who is interested in a fixed index annuity is looking for future money, not cash-in-hand today.

Need More Help?

If you’re looking for more help on annuities or retirement planning, here are some of our favorite resources:

• How Do Annuities Work (just the basics!)
• Should Annuities Be Part of Your Retirement Portfolio?
• Bob Carlson’s Retirement Watch
• Stan the Annuity Man