Indexed Annuities Explained

Although hardly a fairytale, indexed annuities might best be explained in the context of the Goldilocks parable in which they are not too cold (as in low yielding fixed annuities), or not too hot (as in riskier variable annuities), but just right, for investors looking for something in between. Indexed annuities were introduced at a time when fixed annuity rates were coming down from their 1980’s highs, and variable annuities were under a lot of scrutiny for their lack of transparency and high expenses. Indexed annuities were a breath of fresh air for investors who still appreciated the unique features of annuities.

Often characterized as a fusion of fixed annuities and variable annuities, indexed annuities do offer some elements of both, however, they probably hold more appeal for investors who seek a greater degree of safety than those who seek growth type returns. Although their yields are tied to stock market returns, their upside potential is limited, but typically greater than the returns available through fixed annuities. For investors who seek returns north of fixed yield annuities or CDs, and who are still concerned with the preservation of their principal, indexed annuities can be ideal investments.

The Mechanics of Indexed Annuities

Indexed annuities, with their ability to generate rates of return that exceed fixed yield investments while protecting against the loss of principal, may seem to be “too good to be true”. The truth is that they don’t come without some controversy, primarily that they can be fairly difficult to understand. It would stand to reason that, in order to create a financial product that offered only upside with little or no downside, it would have to involve some complexities. After all, indexed annuity providers (life insurers) need to be able to make some money while providing, essentially, no risk returns.

Capturing Market Yields

Like fixed annuities, indexed annuities credit a fixed rate of return for a one year period. Unlike fixed annuities, the indexed fixed rate is linked to the movement of a major stock index. So, the credited yield is derived from the gain in the index, either as a year-over-year percentage, or has an average of monthly benchmarks over a twelve month period. In the year-over-year measure, the annuity yield is based on the actual percentage gain in the index.

Sharing in the Gains

In years in which the stock index experiences a gain, the life insurer credits a portion of the gain based on a pre-determined “participation rate”. The participation rate is the percentage of the actual gain in the index that is credited to the accumulation account. A participation rate of 80% applied to a 15% gain in the index translates to a 12% yield credited to the account. Participation rates can range from 20% to 90% and, unless otherwise stated, may be subject to downward adjustments after the first contract year.

Capping the Gain

After limiting your participation in the gain, the life insurer may also place a cap on the yield it will credit to the account. If the contract calls for an 8% yield cap, then, instead of earning a 12% credit, the account would be credited with 8%. Yield caps also vary and can be as high as 15% or as low as 4%. Yield caps may also be adjusted, so it would be important to study the contract to know when and how much they can change.

Protecting the Downside

Up to this point, it may seem as though the life insurer is simply chiseling away at your return, but there is a very good reason. When the stock index experiences a decline, the life insurer will still credit your account with a minimum rate of return. Essentially, you are giving up a portion of the upside in return for protection against the downside. Minimum rate guarantees can range from 0% (better than a loss of principal) to 3%.

Locking in Your Gains

As if it weren’t enough that your account is credited with a gain even after a stock market decline, the life insurer will further protect your gain by adjusted your basis each year which will ensure that your account balance will never decline in value (unless a withdrawal is made). The actual method for resetting the account balance varies. Some contracts reset year-over-year, and others use a point-to-point method which may cover several years.

Keeping the Rest of Annuity Benefits

Aside from the opportunity to generate higher rates of return in a fixed yield type investment, investors enjoy the same benefits that are standard in fixed annuities of all types.

Tax Deferral:

All earnings are allowed to accumulate without paying current taxes.

Account Access:

Withdrawals of up to 10% of the account balance can be made once annually.

Surrender Fees/Penalties:

Withdrawals in excess of 10% made within the surrender period are subject to a fee which starts out high (as much as 15%) and drops by a point over the course of the surrender period which can last as many as 15 years.

Death Benefit:

As with all annuities, your beneficiaries are guaranteed to be paid a minimum death benefit, which for indexed annuities, is the adjusted principal basis each year.

Guaranteed Income Distribution:

Indexed annuities may be converted into an income annuity which guarantees payments for a specific period of time or for life. The payments may also be linked to a stock index which means they can increase during years when the index gains.


If Goldilocks was an investor, she would probably have chosen an indexed annuity because they are ideal for anyone who doesn’t want the biggest or hottest, nor the smallest and coolest, but something that offers the right amount of upside with the least amount of risk. For annuity investors, indexed annuities can play a vital role in balancing out a portfolio of annuities that might include both fixed and variable annuities.