Key Takeaways
- Fixed index annuities offer a safe and principal-protected way to benefit from market gains, with your contract tied to the performance of an index.
- Pros of this type of annuity include tax-deferred growth, guaranteed minimum returns and the ability to grow your money from market performance without risking your principal.
- Cons include caps on growth, sometimes complex contracts and lack of liquidity.
A fixed index annuity is a long-term savings product whose return is based on a stock market index. While fixed index annuities are often tied to major market indexes such as the S&P 500, they can also be tied to less common indexes depending on the financial institution or insurer that sells them.
Unlike stocks and other types of annuities, fixed index annuities provide security against losses if the market falls. A contract typically ensures that you will never lose your principal in exchange for a cap on potential earnings. Similar to other annuities, they are intended to provide a steady income stream during retirement and can be used to round out a 60/40 investment portfolio.
But along with a cap on earnings, fixed index annuities are generally illiquid, and contracts can be complex.
It’s essential to weigh the pros and cons of a fixed index annuity before determining if one is right for you.
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Pros of Fixed Index Annuities
- Protection from loss
- Minimum return guarantee
- Higher potential return than CDs
- Tax-deferred growth
Protection from Loss
Fixed index annuities are generally safe products because they are designed to protect investors from market downturns while still allowing them to benefit from upswings.
Buying a fixed index annuity is typically structured in a format where you see limited losses when the index it’s tied to declines but benefit from a percentage of the growth when that index improves.
Different products offer several crediting strategies, with options ranging from different indexes to selecting floors and caps that make sense for you.
A floor places a percentage limit on how much you can lose — and a minimum on how much you can earn. For example, if the floor is set at 5% and the index decreases by 12%, you would only lose 5% of your contract value.
Learn how an investment today can provide guaranteed income for life.
Minimum Return Guarantee
Another potential benefit of a fixed index annuity is that the company issuing the product may include a minimum return guarantee.
This means that — even if the index your annuity is tied to declines — you can still experience a small, guaranteed amount of growth. This adds an extra level of safety to the product, guaranteeing you at least some level of return.
Higher Potential Return Than CDs
In some ways, fixed index annuities operate similarly to CDs by presenting a safe way to grow your money at a solid rate. The main difference, of course, is that fixed index annuities base their rate of growth on an index, while CDs generally offer a fixed rate.
That chance to participate in the market’s upside allows fixed index annuities to offer potentially higher returns than CDs. Ultimately, the rate of return is dependent on the market environment and the prevailing interest rates during the investment period.
Additionally, the tax deferral component offered through fixed index annuities is not available with a CD. This means your money can grow even more than it would in a CD since your interest can go untaxed while it grows.
Indexed Annuities have a 3.27% average annual return*
*Based on a study from 2007-2012
CDs have a 1.76% average annual return*
*Based on 12-month CDs from 12/31/2001-12/31/2020
Tax-Deferred Growth
Tax-deferral is a significant benefit of opting for a fixed index annuity since it’s a feature not commonly available through many financial products.
When you purchase an annuity, you will only owe taxes once you withdraw money from the product. This is a notable difference from a CD, where you pay tax on the annual interest earned.
Since the money in your annuity account is untaxed, you have the opportunity for even more growth since that money can continue to compound on itself uninhibited through the course of your contract term.
The obvious benefit to fixed index annuities is the downside risk protection. These annuities offer investors protection from market losses while still offering (limited) growth portential connected to the underlying market index.
However, these are complex contracts and should be entered into only with complete understanding of the terms, rules, and costs. These products will not produce equity-like returns since the growth limitions usually cap or reduce upside potential in exchange for the negative performance protection.Stephen Kates, CFP®Principal Financial Analyst for Annuity.orgStephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.
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Cons of Fixed Index Annuities
- Complex products
- Generally Illiquid
- Less certainty than other options
Complex Products
One downside of fixed index annuities is that they are generally complex products. This is not a simple or quick purchase like acquiring a CD.
Buying a fixed index annuity often requires working with an agent or financial professional, assessing options from multiple companies and going through a lengthy purchase/application process.
The contract itself can also get confusing. There are many details to hash out with an annuity, ranging from withdrawal and liquidity options to exactly how you are credited for the growth of the index your product is tied to.
Customers who are looking for a quick or simple way to get started that requires little pre-planning may have trouble stomaching the complexity of fixed index annuities.
Generally Illiquid
Once you invest in a fixed index annuity, you give up control of the principal in the short term. Even though CDs and bonds work similarly, this concept can make some customers uneasy.
After purchasing your fixed index annuity, you typically cannot touch your money until the annuity term is complete. Most products sold by major companies offer you the ability to withdraw up to 10% of the value of the annuity during that period.
However, if you attempt to withdraw more than that, you will face steep penalties of 7% or more.
It is standard industry practice for fixed index annuity contracts to include a few outs for customers covering severe situations.
It’s often stipulated that you can withdraw the total value of the annuity at any time if you are diagnosed with a terminal illness or must enter a nursing home.
Less Certainty Than Other Options
Fixed index annuities have much less built-in risk than directly investing in the market. However, they still have a higher degree of uncertainty than other types of annuities and financial products.
With a multi-year guaranteed annuity, for example, you lock in your product at a guaranteed rate for a set amount of time. You know exactly how much your cash will grow and when you will receive the payout. The same is generally true for CDs.
Fixed index annuities offer some certainty in the form of caps and floors, but the market is ultimately unpredictable.
You’ll never know exactly how much your money will grow since it is based on an index’s performance.
Fixed Index Annuity Alternatives to Consider
If you’re unsure if fixed index annuities are the right option for you, there are alternatives worth considering.
Fixed annuities offer fixed rates of return that let you benefit from generally high rates without any market risk.
CDs operate similarly, offering higher interest rates than traditional savings accounts while restricting access to your funds for a set period.
Bonds are debt securities under which an investor lends money to a borrower for a certain amount of time in exchange for interest payments. They are often considered straightforward and low-risk investments.
The choice that makes the most sense for you will likely come down to your goals and your risk appetite. Speaking with a financial advisor can help you clarify your options and which choice you stand to benefit from the most.
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