How Does an Indexed Annuity Differ From a Fixed Annuity?
Understand how fixed and indexed annuities differ in their approach to growth and security, guiding your financial planning decisions.
Annuities are financial products designed as contracts with an insurance company, primarily serving to provide a steady stream of income, often during retirement. They function by allowing an individual to contribute funds, either as a lump sum or through a series of payments, which then grow over time. Later, these accumulated funds can be converted into regular disbursements, providing a predictable financial resource. This article aims to clarify two common types of annuities: fixed annuities and indexed annuities, and to delineate their key differences.
Fixed Annuities Explained
A fixed annuity is a contract where the insurance company guarantees a specific, predetermined interest rate for a set period. This provides a high degree of predictability and stability in the growth of the invested funds. The interest rate might be guaranteed for multiple years, typically ranging from three to ten years, as seen in multi-year guaranteed annuities (MYGAs). Alternatively, some fixed annuities may declare an annual interest rate that cannot fall below a guaranteed minimum specified in the contract.
Fixed annuities protect the principal investment, shielding the money contributed from market downturns and ensuring initial capital remains intact. During the accumulation phase, earnings grow on a tax-deferred basis, meaning taxes are not due until withdrawals begin. When funds are eventually withdrawn, they are taxed as ordinary income.
Withdrawals made before age 59½ may incur an additional 10% federal tax penalty. Fixed annuities often include surrender charges if funds are withdrawn early or the contract is terminated before a specified period. These charges are typically highest in initial years, sometimes ranging from 5% to 10%, and then gradually decline. The guaranteed nature of fixed annuities makes them a conservative option for individuals prioritizing capital preservation and consistent, albeit modest, growth.
Indexed Annuities Explained
An indexed annuity is a contract that offers returns linked to a market index, such as the S&P 500, without direct market investment. It protects the principal investment from market downturns; even if the index performs negatively, the annuity’s principal value will not decrease due to market losses.
Interest credited to an indexed annuity is determined by a participation rate, a cap rate, and a floor. The participation rate dictates the percentage of the index’s gains credited. For instance, if an index gains 10% and the annuity has an 80% participation rate, 8% of that gain would be credited. Participation rates can be adjusted annually by the insurer.
The cap rate sets the maximum interest earned in a period, regardless of index performance. For example, if an annuity has a 6% cap and the index gains 10%, only 6% would be credited. Cap rates, like participation rates, can be adjusted annually. The floor is the minimum interest rate credited, often 0%, ensuring no loss of principal or previously credited interest due to index declines.
Comparing Fixed and Indexed Annuities
The primary distinction between fixed and indexed annuities lies in their interest crediting methods. Fixed annuities provide a guaranteed, predetermined interest rate for a specific period, offering consistent and predictable growth unaffected by market fluctuations. In contrast, indexed annuities link their potential returns to the performance of a market index, allowing for growth that fluctuates with the market, albeit with certain limitations.
Regarding growth potential, fixed annuities offer predictable and steady accumulation, making them suitable for those who prioritize certainty over higher potential returns. Indexed annuities, while offering the potential for higher gains than fixed annuities due to their market linkage, cap these returns through participation rates and cap rates. This means that even in exceptionally strong market years, the interest credited to an indexed annuity will be limited, and will not fully capture the index’s performance.
The complexity of these products also differs. Fixed annuities are more straightforward, as their guaranteed interest rates simplify future value calculations. Indexed annuities involve more nuanced calculations due to the interplay of participation and cap rates, requiring a thorough understanding of how these factors influence credited interest. This added complexity can make their performance less transparent.
The predictability of returns is another differentiating factor. Fixed annuities offer highly predictable returns. Indexed annuities, while protecting principal, have less predictable returns because their credited interest depends on the market index’s performance, which varies year to year.
Both types of annuities typically offer principal protection, safeguarding the initial investment from market losses. However, how this protection interacts with potential gains varies. In a fixed annuity, the principal grows at a guaranteed rate regardless of market conditions. With an indexed annuity, the principal is protected from market declines by a floor, often 0%, but any positive market performance is only partially captured due to caps and participation rates. This trade-off allows indexed annuities to offer some market upside while maintaining principal safety, a balance that fixed annuities do not aim for with their purely guaranteed returns.