Key takeaways:
Fixed index annuities offer the potential for market-linked growth while protecting your principal from market losses, making them a middle ground between fixed and variable annuities.
Growth is tied to the performance of a market index, but returns are typically limited by factors such as participation rates, rate caps, spreads, fees, and other contract terms.
Like other deferred annuities, fixed index annuities provide tax-deferred growth, but withdrawals are generally taxed as ordinary income and may incur penalties if taken before age 59½.
Before purchasing a fixed index annuity, it’s important to understand the available index strategies, fees, surrender charges, payout options, and optional riders that may affect long-term performance.
Fixed index annuities may be a good fit for investors seeking retirement income with greater downside protection than market-based investments while still maintaining some opportunity for growth.
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 versus 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 annuities generally include a guaranteed minimum interest rate, while fixed index annuities typically have greater potential for growth — but that growth isn’t guaranteed and returns are typically limited by caps, participation rates, or spreads.
Fixed index versus 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, a fixed index annuity does not involve direct investment in the underlying assets; instead, it is linked to the selected index’s benchmark, and the interest credited depends on market 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 index annuities
Weigh the benefits of a fixed index annuity against the drawbacks as you consider this investment option in light of your financial goals and retirement plan.
Advantages | Disadvantages |
Potential for growth | Growth isn’t guaranteed |
Downside risk protections | Fees, caps, spreads, and other costs eat into your returns |
Gains grow tax-deferred until withdrawal, when you will likely be in a lower tax bracket | You may have to pay a surrender penalty if you withdraw your funds before age 59½, and taxable amounts may be subject to ordinary income tax treatment and penalties |
Principal protection | No 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, and optional riders may provide guaranteed lifetime income. Some riders can also enhance death benefits for beneficiaries.
Tax implications
A fixed index annuity defers taxes until you withdraw the funds, typically in retirement. Under current tax law, withdrawals from a fixed index annuity 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 59½) will trigger standard income taxes plus an extra 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%, which limits upside potential even when the market performs well. Even if the underlying index that it is pegged to rises 10% or 12%, your yield for the year will still 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), and that rate affects how much of market gains are used to calculate returns. Participation rates determine how much of the index’s return rate is credited to the annuity, so it can earn interest based on index performance, but only the portion allowed by the participation rate is credited. 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 preserves prior interest credited during market downturns and periods of market volatility, which helps cushion the effects of market fluctuations 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.
Work with a registered representative to submit an application.
Select the index strategy you want, or allocate funds among multiple index strategies.
Select optional riders, if desired.
Select your beneficiary.
Make the initial investment deposit.
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 10- or 20-year fixed term or lifetime payments.
You can usually withdraw money from these annuities before age 59½ as well — but it’s not always a good idea. These early withdrawals can have tax, interest, and fee implications. In other words, taxable amounts are generally subject to ordinary income tax, a federal tax penalty, and a withdrawal charge. Because growth is tax-deferred, amounts withdrawn may be taxed at that time, and charges can still apply. 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 to protect your retirement savings while still having the potential for market-based growth. 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, which may make it a good fit.
Get professional advice on annuities
A local Guardian financial advisor can explain your options and help evaluate how a fixed index annuity may fit into your financial goals and retirement income needs.
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% and 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.
