What is an indexed annuity?

How does an indexed annuity work?

Planning for retirement can be a balancing act. On the one hand, there’s the desire to grow your nest egg. On the other hand, there’s the need to protect it from risk. Indexed annuities can help you meet both requirements.

An indexed annuity is a deferred annuity that allows you to save tax-advantaged dollars before retirement with the potential for faster growth through some exposure to market index performance (although it is not a direct investment in an index) and some protection against losses. An indexed annuity’s rate of return is related to the performance of index funds like the S&P 500 or the Nasdaq 100.

One form of indexed annuity is the fixed-index annuity in which all or a portion of your interest is subject to the market, but the principal is not directly invested in the market. This distinction allows for more growth if the index performs well (the growth is subject to a cap)—while providing protection from loss if the index performs poorly.

How does an indexed annuity differ from a fixed annuity?

An indexed investment is tied or indexed to the performance of a stock market index, and when the index experiences growth, so does your annuity. Certain caps specified by the annuity contract limit the amount of growth and the potential losses you will experience. A fixed annuity, by contrast, grows at a rate guaranteed by the contract and provides a predictable and steady return.

How does an indexed annuity differ from a variable annuity?

While indexed annuities are linked to market index performance with performance cap and floor provisions, a variable annuity can offer uncapped exposure to variable investment options that involve investment risk. However, some variable annuities may offer index-linked investment options that are structured like an indexed annuity.

Related: Learn more about the three primary types of annuities

What you should know when purchasing an indexed annuity

Indexed annuities offer several benefits, but they can be complex. Here are a few things you should know before purchasing one:

The track record of the provider

When purchasing an annuity, or any financial product, you’ll want to work with a company that has a strong reputation for reliability. New York life has a history of over 175 years of excellent service and honoring claims.

Options for funding the annuity

You can set up your annuity with a lump-sum payment or by making premium payments over time.

The terms and conditions of the annuity contract

The following benefits and conditions of indexed annuities are designed to allow you to participate in market gains while limiting exposure to losses caused by market volatility. These terms vary by insurance company, and some may have associated fees. Be sure to learn the specific terms of an annuity product before making a purchase to avoid surprises later.

Minimum guaranteed return

Some annuities guarantee a minimum amount of growth per year. So if the index that your annuity is tied to loses money, your contract will prevent you from realizing a loss. Depending on the terms, you may still receive a positive return.

Loss floor

Many fixed index annuities protect your principal by limiting the amount you can lose regardless of market performance. For example, if the market went down by 7%, and your annuity contract caps your losses at 3%, you would not be charged with the remaining 4%.

Participation rates

Most fixed index annuity contracts specify a participation rate. This rate refers to the percentage of market gains that your annuity will pay. Some plans will pay up to 100%, but participation rates often range anywhere from 25% to 90%. Let’s say your participation rate is 90%. If the index gained $100, you’d receive $90, and the insurance company would keep the rest.

Rate caps

Some annuity contracts also specify a maximum return per year, referred to as the rate cap. For example, if the market gains 20%, but your rate cap is 10%, then you will receive only 10%, as specified in your contract. It’s worth noting that annuities can be subject to both rate caps and participation rates, further lowering your returns.

Spread/margin/asset fees

An insurance company can also charge a percentage fee against the index return. For example, if the market gained 8% and the spread fee is 2%, your account would receive only 6% in gains.

Riders

To make sure your annuity covers specific needs, you can also purchase riders. Riders can include lifetime guaranteed income, death benefits, and other provisions. The extras provided through riders can reduce the amount of returns you receive.

The terms of indexed annuities can be complicated. Consulting a financial professional is the best way to set one up that meets your needs.

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