Are Annuities Affected by the Stock Market?

An annuity is a contractual agreement, typically with an insurance company, designed to provide a steady income stream, often during retirement. The extent to which an annuity’s performance is influenced by the stock market varies significantly, depending on the specific type of contract. Understanding these differences is essential for financial planning.

Fixed Annuities and Market Influence

A fixed annuity offers a guaranteed interest rate for a predetermined period, providing a predictable growth path for the invested principal. This structure means that the principal and any accumulated interest are protected from fluctuations or downturns in the stock market. The returns generated by a fixed annuity are based solely on the fixed interest rate promised by the insurance company, not on the performance of market indices or underlying investments.

Fixed annuities are generally not directly affected by the day-to-day or even yearly performance of the stock market. While an existing fixed annuity contract remains insulated from market volatility, the interest rates offered on new fixed annuity contracts can be indirectly influenced by the broader economic environment. This includes prevailing interest rates set by central banks and other economic conditions.

Variable Annuities and Market Influence

Variable annuities allow the contract owner to allocate their investment among various underlying sub-accounts, which function similarly to mutual funds. These sub-accounts can invest in a diverse range of assets, including stocks, bonds, or money market instruments. The value and returns of a variable annuity are directly tied to the performance of these chosen underlying sub-accounts.

If the stock market experiences a period of growth, the value of the sub-accounts, and consequently the annuity, will likely increase. Conversely, a downturn in the market will directly reduce the annuity’s value, as the underlying investments lose value. Variable annuities offer the potential for greater growth than fixed annuities because they participate in market upside, but they also carry market risk, meaning the principal is subject to loss.

Indexed Annuities and Market Influence

Indexed annuities link their returns to the performance of a specific stock market index, such as the S&P 500, without directly investing in the index itself. This design provides a balance, offering principal protection from market losses while allowing for participation in a portion of the market’s gains. The principal invested in an indexed annuity is typically guaranteed not to decline due to market performance.

The mechanisms governing indexed annuity returns include participation rates, caps, and floors. A participation rate determines the percentage of the index’s gain that is credited to the annuity; for example, an 80% participation rate means the annuity earns 80% of the index’s increase. A cap sets the maximum percentage gain that can be credited to the annuity in a given period, regardless of how high the index performs.

The floor is the minimum guaranteed return, which is often zero percent, ensuring no loss of principal due to market declines. While their returns are influenced by market performance, indexed annuities are not directly invested in the market and incorporate built-in protections that limit both potential losses and upside gains.

Other Factors Affecting Annuity Performance

Beyond direct market influence, several other factors can impact an annuity’s overall performance and net returns received by the contract owner. The prevailing interest rate environment, separate from stock market movements, plays a role. Higher interest rates generally allow insurance companies to offer more attractive crediting rates on new fixed annuity contracts or influence the crediting methods for indexed annuities.

Fees and expenses can considerably reduce the net return of variable and indexed annuities, irrespective of market performance. These charges can include mortality and expense risk fees, which may range from 0.5% to 1.5% of the policy value annually, administrative fees, often around 0.3% of the annuity’s value, and underlying sub-account management fees, potentially adding 0.25% to 3% per year. Additionally, costs for optional riders, such as guaranteed lifetime income benefits, can further impact returns, typically ranging from 0.25% to 1% of the annuity’s value annually.

Annuities typically incorporate surrender charge periods, during which early withdrawals can incur penalties. These periods commonly range from three to ten years, with surrender charges often starting at around 7% to 10% in the first year and gradually declining each year until the period ends. For instance, a withdrawal in the first year might incur a 7% charge, decreasing to 6% in the second year, and so on. Many contracts allow a free withdrawal provision, enabling the owner to withdraw a designated portion, often 10% of the account value, each year without incurring a surrender charge. Such charges reduce the net amount received if funds are accessed before the end of the surrender period.

Regarding taxation, earnings within annuities grow tax-deferred, meaning taxes are not paid until distributions begin. When withdrawals are made, the earnings portion is generally taxed as ordinary income. For non-qualified annuities, which are funded with after-tax dollars, only the earnings are taxed upon withdrawal, and generally, the “last-in-first-out” (LIFO) rule applies, meaning earnings are taxed first. If withdrawals from any annuity are made before age 59½, they may be subject to a 10% federal income tax penalty, in addition to ordinary income tax on the taxable portion. Qualified annuities, funded with pre-tax dollars through retirement accounts like 401(k)s or IRAs, are fully taxable upon withdrawal, as both contributions and earnings have not been previously taxed.