An index annuity is an annuity whose rate of return is based on a market index, such as the S&P 500 or the Nasdaq 100. An indexed annuity sets limits on your potential gains and losses, so these annuity contracts are less risky than investing directly in the market but also have less upside.
How Does an Index Annuity Work?
Like most annuities, index annuities can provide you with a steady stream of income in retirement. Before you start receiving any income, though, you must first agree to and fund a contract. Your contract will spell out how you will fund your annuity—all at once with a lump sum or with steady payments over time—and when you can begin to make withdrawals.
The annuity company will invest your money using the index you select. The exact indexes available depend on the annuity company, but common indexes include the S&P 500, the Nasdaq 100, the Russell 2000 and the Euro Stoxx 50. You can put all your money in one index or split it across several.
Equity indexed annuities may be safer than investing directly in index funds because the annuity company protects you against losses. That, of course, comes with the tradeoff that you won’t earn the same high returns that an index fund outside of an annuity might have.
Index Annuity Returns
The amount your indexed annuity earns is based on the underlying index. Let’s say you buy an S&P 500 index annuity. When that market goes up, you make more money, but when the market goes down, you earn less and may even lose money. The long-term annual average rate of return for the S&P 500 is about 10%. But you won’t see quite that return on your investment.
Index annuities don’t pay out the exact return of the index. Instead, they use a system to limit both your potential losses and your potential gains. That’s why this product is also called a fixed index annuity—because your losses and gains fall within a fixed limit. These limits are normally set using a combination of the following:
Minimum guaranteed return. The annuity company could guarantee a baseline minimum return each year, even if the underlying index loses money. For example, it might pay 1% even if your target index has a negative return for the year.
Loss floor. Your contract may also include a loss floor, which is the most you could lose in a market downturn. A contract might set your floor at 10%, which means 10% would be the most of your deposit you could lose from market losses.
Adjusted value. Your index annuity may lock in your gains periodically. In other words, if your balance goes up, the annuity company could guarantee that it would not fall below that new adjusted value, even if the index loses money in the future.
Return caps. On the other end, the annuity company might set a maximum possible return per year. For example, the most you could earn might be 6% per year, even if the underlying index earns more.
Participation rate. Participation rate describes the percentage of index returns that the annuity will pay. If your participation rate was 70%, you would only receive 70% of the index gains. If the index went up 10%, you’d receive 7% (10% x 70%).
Spread/margin/asset fees. The annuity company may deduct a fee from the index return. If its fee were 4% and the index returned 10%, your gain would be 6% (10% minus 4%).
Index Annuity Withdrawals
Besides growing your savings, one of the appeals of an index annuity is the income it can generate for you. Index annuity payments can last over a set number of years or can be guaranteed for your entire life, depending on your contract. Like most tax-advantaged retirement accounts, investment gains are taxed upon withdrawal.
Payments for index annuities are classified in two main ways:
An immediate annuity starts paying money back to you within a year of you signing up. A deferred annuity, on the other hand, holds onto your money for at least a year before distributing payments. The longer you wait, the more the index annuity will grow your balance and therefore the greater potential future payments you’ll have.
We'd love to sit down and talk to you about your 401k and IRA rollover into an indexed annuity. If you're still holding on to your 401k, take a look at this video below: