What Is an Indexed Annuity?

An indexed annuity is a special class of annuities that yields returns on contributions based on a specified equity-based index. One can purchase this annuity from an insurance company, and similar to other types of annuities, the terms and conditions associated with payouts depend on what the original annuity contract says.

How Indexed Annuities Work

Indexed annuities offer annuitants the opportunity to earn higher yields based on stock market performance with protection against market declines. However, it is also common for an annuitant to experience lower-than-expected yields due to the combination of caps on the maximum amount of interest earned and fee-related deductions. The real challenge is in understanding how an indexed annuity works, as it is much more complex than a standard fixed annuity.

The rate on an indexed annuity is calculated as a percentage of the gain in the Standard & Poor’s 500 Index. The actual percentage applied to the credit rate is based on the year-over-year gain in the index or the average monthly gain over a 12-month period.

In a year when the stock index realizes a gain, a portion of the gain is credited to the account based on a participation rate dictated by the life insurer. The participation rate can be as high as 100 percent, meaning the account is credited with all the gain, or it can be as low as 25 percent. Most products offer a participation rate between 80 and 90 percent — at least in the early years of the contract. For example, if the stock index gained 15 percent, an 80 percent participation rate translates to a credited yield of 12 percent. Most products offer a high participation rate in the first year or two, but then the rate adjusts downward.

Key Takeaways

  • An indexed annuity is a type of variable annuity contract that delivers cash flows to the annuitant based on the return of a stock index, usually the S&P 500.
  • Indexed annuities give people the opportunity to enhance their annuity income, but fees and caps may limit the potential upside actually returned.
  • In down years for stocks, the annuity will still typically be credited by some minimum rate.

Indexed Annuities and a Yield or Rate Cap

Most indexed annuity contracts include a yield or rate cap that can further limit the amount credited to the accumulation account. For example, a 7 percent rate cap limits the credited yield to 7 percent no matter how big the stock index gain. Rate caps can range from a high of 15 percent to as low as 4 percent and are subject to change.

In years when the stock index declines, the issuing company credits the account with a minimum rate of return. A typical minimum rate guarantee is about 2 percent. Some can be as low as 0 percent and as high as 3 percent.

At specific time intervals, the insurer adjusts the basis of the account upward to include the gain in value that occurred in that timeframe. The principal, which the insurer guarantees, never declines in value unless there is a withdrawal, and the amount guaranteed to the beneficiaries increases over time. There are several methods used to adjust the basis, such as a year-over-year reset or a point-to-point reset, which incorporates two or more years' worth of returns.