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Fixed index annuities: What they are and how they work

Growth potential with protection from losses
Guardian Life Insurance of America
Written by

Reviewed by

Fixed Index Annuity

Fixed index annuities are a type of deferred annuity that allows the premiums you contribute to grow for a number of years before taking income in retirement. The primary advantage is that this type of annuity offers protection against market losses and the potential for gains based on an underlying stock market index, such as the S&P 500. Take a minute to learn how these annuities can offer a tax-advantaged way to balance market-level returns with downside protection, plus:

  • How they compare to other types of annuities

  • Pros and cons

  • How to buy a fixed index annuity

  • Who this annuity type is best suited for

What are fixed index annuities?

A fixed index annuity is a kind of deferred annuity: A guaranteed contract with an insurance company designed to accumulate savings over time and provide income in the future. Your earnings typically aren’t taxed until you withdraw them. After the accumulation period, you can typically choose to receive a lump sum, spread payments out over a fixed number of years, or receive income for the rest of your life.

Unlike some annuities that expose you to market risk, fixed index annuities protect your principal until you decide to take guaranteed income in retirement while offering tax advantages, market growth potential, and a floor to protect against losses. It’s tied to an underlying market index, so when the index rises, so do your gains, up to a limit outlined in your contract. But, it’s important to know that the interest you earn won’t match the index’s total performance due to fees, rate caps, spreads, and/or participation rates. On the other hand, if the index falls, your principal is protected from losses.

How fixed index annuities compare to other types of annuities

Fixed index annuities combine features of both fixed annuities and variable annuities, but they’re a unique product.

Fixed index vs fixed annuities

A fixed annuity has a guaranteed rate of return, which is typically set for a number of years, then resets to reflect changes in market rates — similar to the way CDs work. When you decide to annuitize (take income), you can then elect to receive set income payments over a set number of years or for life. A fixed index annuity, in contrast, earns returns that are tied to the performance of an underlying equity index, subject to floors and caps. Fixed index annuities typically have greater potential for growth than fixed annuities – but the growth in an index annuity isn’t guaranteed.

Fixed index vs variable annuities

During the accumulation phase, a variable annuity puts the premiums directly into the investments you choose (e.g., equity accounts that resemble mutual funds), and you bear the investment risk: if your investments go down, your contract loses value. Unlike a variable annuity, funds in a fixed index annuity earn returns that are based on (but not exactly equal to) the selected index’s performance: The floor protects you from losses in down years, and upside performance is capped when the index is up. A fixed index annuity offers greater protection from investment risk than a variable annuity but more limited growth potential.

Advantages and disadvantages of fixed indexed annuities

Weigh the benefits of a fixed index annuity against the drawbacks as you consider this investment option.

Advantages

Disadvantages

Potential for growth

Growth isn’t guaranteed

Downside risk protections

Fees, caps, spreads, and other costs eat into your returns

Taxes are deferred until withdrawal, when you will likely be in a lower tax bracket

You may have to pay a surrender penalty (plus applicable taxes) if you withdraw your funds before age 59 ½

Principal protection

Important things to consider before you buy a fixed index annuity

You have choices

When buying a fixed index annuity, you’ll typically have a choice of indexes to base potential growth on. After the accumulation period, you can typically choose to receive a lump sum, take payments for a fixed period, or receive income for the rest of your life.

Tax implications

A fixed index annuity defers taxes until you withdraw the funds, typically in retirement. Withdrawals at that point are subject to ordinary income tax — but most retirees expect to be taxed at a lower rate than during their working years. Also, in most cases, early withdrawals (before age 59 ½) are subject to a 10% federal tax penalty.

Yields and rate caps

The yield on a fixed index annuity may be capped at a certain percentage, for example, 7%. Even if the index that it is pegged to rises 10% or 12% your yield for the year will be limited to 7%. Your annuity contract will spell out the rate cap.

Participation rates

Performance may be limited by a participation rate instead of a rate cap (although some annuities may have both). Participation rates determine how much of the index’s return rate is credited to the annuity. So if the index rises 10% but your participation rate is 80%, you’ll see 8% growth — not 10%. However, sometimes the participation rate is greater than 100%, in which case you will see growth that is greater than the index performance.

Adjusted values

At the end of each term,, the insurer will adjust the value of the annuity to reflect any gains. This adjusted value prevents you from losing those gains if the index declines by the end of the renewal term.

Fees and costs

A fixed index annuity may have a variety of costs which can reduce its overall growth potential. These may include:

  • Administrative fees

  • Rider fees

  • Rate spreads

  • Commissions

  • Mortality expenses (M&E)

  • Surrender charges for early withdrawal

How to buy and set up a fixed index annuity

If you’re interested in the advantages of a fixed index annuity, you can purchase one from an insurer (such as Guardian) that offers the product. Make sure that the issuing insurance company has an outstanding track record for financial strength and claims paying ability.

  1. Work with a Registered Representative to submit an application.

  2. Select the index strategy you want, or allocate funds among multiple index strategies

  3. Select optional riders, if desired

  4. Select your beneficiary

  5. Make the initial investment deposit

  6. After an initial term, you may be able to change your index allocation, if desired and allowed by your contract

Your investment may earn returns as outlined in your contract. The insurance company should provide regular communications or statements (at least annually) showing you your account value.

How to withdraw from a fixed index annuity

When you’re ready to withdraw funds in retirement, contact the insurance company to ask about your options and how to proceed. Most contracts (but not all) will allow a lump-sum withdrawal, or a choice of annuitization options, such as payments that last for a 10- or 20-year fixed term or lifetime payments.

You can usually withdraw money from these annuities before age 59 ½ as well — but it’s not always a good idea. These early withdrawals can have tax, interest, and fee implications. In other words, you may have to pay regular income tax, a federal tax penalty, and a withdrawal charge. However, you might be able to qualify for a waiver if you meet certain criteria, such as entering a nursing facility, developing a terminal illness, or losing unemployment.

Who are fixed index annuities best for?

A fixed index annuity may be right for you if you want the potential for market-based growth but are worried about protecting your principal. Unlike directly investing in stocks or other securities, which carry full market investment risk, a fixed index annuity usually has a floor that protects you from negative index returns.

Get professional advice on annuities

A local Guardian financial professional can explain your options and provide advice to help you reach your goals.

Need some help?

Find a financial professional near you who can help

1 https://www.annuityexpertadvice.com/the-average-return-on-annuities/

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Frequently asked questions about fixed index annuities

The answer depends on your investment goals, your retirement income needs, and your willingness to accept investment risk. To decide whether this specific type of annuity is a good investment for your goals, you should weigh the “costs” of decreased growth potential due rate caps, participation rates, and fees, against the benefits of index-based returns and protection from market downturns.

Because of the structure of a fixed index annuity, returns will generally be lower than the index it tracks, but according to The Annuity Expert, you might expect an average return between 5% to 7%, for example.1

It’s possible to lose money with a fixed index annuity, but if you do, it’s likely because you have withdrawn too much or too early, and as a result, paid withdrawal charges and penalty taxes. If you leave the funds in place, your premium contributions are typically protected from losing value.