How Does an Indexed Annuity Differ from a Fixed Annuity?

Annuities come up in virtually every retirement planning discussion. The second or third question in the discussion of how a guaranteed stream of income during retirement can figure into a financial plan is: How does an indexed annuity differ from a fixed annuity? 

The very short version? An indexed annuity (also called a fixed-indexed annuity or FIA) has much higher growth potential than a fixed annuity without the downside risk of a variable annuity. 

Keep reading to learn the nuances. (Annuities can be complicated. Get the overview here.) Then, determine which type may be a better fit for your financial goals among all the financial products to choose from to build your retirement savings. 

Fixed Annuities Provide Guaranteed Rates of Return

A fixed annuity provides a guaranteed rate of return for a specified period. Insurance companies designed this type to offer stability and predictable income, making it an attractive option for conservative investors. It also offers peace of mind for retirees who worry about losing the principal on their investment and want to make sure their money lasts longer than they do. 

Typically, guaranteed returns range in the 3% to 6% range, historically closer to 3% or 4%. 

What is a Fixed Annuity, Technically Speaking?

A fixed annuity is a contract between you and an insurance company. You provide the premium payment, and the insurer promises to pay you a set interest rate for a number of years. This period is called the accumulation phase. 

During the payout phase, the insurance company converts your accumulated money in the annuity into an income stream. This income can last for a set period, for your life, or even for you and your spouse’s lifetimes. 

Fixed annuities create a safe and predictable investment option. Safe, in this case, means it’s not subject to stock market volatility. The safety of your investment does depend on the financial stability of the company. 

Many people find fixed annuities similar to a high-interest savings account or CD but with tax-deferred growth until the annuitization phase. 

Interest Rate Guarantee

People choose fixed-rate annuities because of the interest rate guarantee. The insurance company offers a guaranteed minimum interest rate, which offers stability, a feeling of security, and peace of mind. 

The guaranteed rate varies depending on the insurance companies, the terms of the contract, and the current federal interest rate. It is typically higher than what you might receive on a Certificate of Deposit (CD) from your bank. 

You lock in the rate when you sign the contract, and it remains fixed for the accumulation period. 

Types of Fixed Annuities

Most fixed annuities come in two types: 

1. Traditional Fixed Annuities offer a fixed interest rate for the accumulation phase. This means guaranteed returns. However, these returns are typically moderate. 
2. Multi-Year Guaranteed Annuities offer a fixed interest rate for a set number of years, usually 3 – 10. After the guarantee period ends, the rates may change, you can choose to renew, or you can transfer the funds to another annuity or other investment vehicle. (Watch out for retirement rules and taxes on this last option.)

Indexed Annuities Offer Higher Returns Without Principal Risk

An indexed annuity, also called a fixed index annuity or fixed-indexed annuity, combines the security of a fixed annuity with the potential for greater returns by linking the accumulation to the performance of a stock market index, such as the S&P 500. 

Unlike variable annuities, in which you can lose some of your money in a bad year, the contract sets a floor for the rate of return. The floor, which is often 0% growth, means that you won’t lose your principal or any previous gains. 

It balances security with increased rates of return, improving your chances that the income from the annuity will be sufficient to cover your needs in retirement because the gains are not eroded by inflation. 

For example, if you have a fixed indexed annuity with a rate of return of 3% and inflation stays at a consistent 2% to 2.5%, your growth is barely outpacing inflation. 

What is an Indexed Annuity, Technically Speaking?

An indexed annuity ties to a market performance index. The insurance company credits interest to your account based on the performance of a stock market index, such as the S&P 500. 

However, if the index returns are negative in a given year, you may not gain any interest. But – and this is more important – you will not lose any money. 

Important Note: In most cases, indexed annuities outperform fixed annuities over time. 

Finally, indexed annuities do not directly invest your money in the market. Instead, the insurance company uses the index as a benchmark for your return percentage. This is how they can guarantee your principal protection. 

Potential for Higher Returns 

Indexed annuities do have the potential for higher returns than fixed annuities. They have downside protection, ensuring you won’t lose money in a year when stock market indexes are negative. 

There is also a participation rate or rate cap to balance out the floor return. If the market has an exceptional year, your annuity might only credit your account up to the predetermined cap rate. 

Key Differences Between Fixed and Indexed Annuities

Choosing between an indexed annuity and a fixed annuity requires some nuance. As the advice goes, “don’t invest in something that you don’t understand.” So, let’s clarify the nuances. 

Interest Rate Structure

The main difference between fixed and indexed annuities is how the insurance company credits your interest. Fixed annuities have a guaranteed rate of interest that gets locked in when you purchase the contract. Indexed annuities base your interest on the performance of a market index. Fixed annuities provide certainty of what you will get. Indexed annuities typically have higher returns over the long run and avoid exposure to loss. 

Risk Levels and Market Exposure

Insurance companies write fixed annuities for conservative investors who want known quantities over all things. These investors will trade growth for predictable returns. Indexed annuities balance safety and growth, making them a reliable choice for investors who want both the security of a protected principal and the security of growing their money enough to outpace inflation. 

Flexibility and Access to Funds

With both fixed and indexed annuities, you will face restrictions and surrender charges if you withdraw your money early. Some annuities (such as the ones we prefer) usually offer penalty-free withdrawal options up to 10% per year. 

Pros and Cons of Fixed Annuities

Advantages of Fixed Annuities

• For the extremely conservative investor, you know exactly what you will get. 

Disadvantages of Fixed Annuities

• The fixed rate is often low (in the 3% to 6% range)
• May not keep pace with inflation
• May only be fixed for a time (terms of 1 – 10 years)

Pros and Cons of Indexed Annuities

Advantages of Indexed Annuities

• You can earn more than fixed annuities in years of strong market performance
• You have a downside protection on your account, unlike a variable annuity, meaning you cannot lose money.

Disadvantages of Fixed-Indexed Annuities

• Can be more complex than fixed annuities
• A year with 0% return can be disappointing

Surrender Charges: What to Consider

Both types of annuity come with surrender charges if you want to return your contract during the accumulation period. These charges typically do not exceed 10% and typically drop a small amount for each year you hold the contract. 

Which Annuity Is Right for You?

An annuity contract is something that you’ll rely on as an income stream in your golden years. Its job is to provide peace of mind that you won’t go broke and see what the job market has to offer an octogenarian. 

Assessing Your Risk Tolerance

If you worry more about consistent growth than inflation and want a predictable return, a fixed annuity might be the better option for you. However, if you want to make sure that your income stream will be sufficient even with inflation doing who-knows-what, an indexed annuity will likely be the right choice. 

Understanding Your Retirement Goals

If your annuity is going to cover a known, fixed expense, then a fixed annuity will let you dial in exactly how much you’ll get when you annuitize the contract for income payments. One example might be if you have a mortgage that you want to pay down and know what you’ll pay each month. 

If you’re hoping to use it as a more general income stream, the extra upside potential on fixed index annuities can help ensure that you will have enough money to fund your retirement. The likelihood of a higher interest rate averaged out over a longer accumulation period means you have odds of a higher monthly income. In this case, an indexed annuity is a good fit.

Evaluating the Time Horizon for Investment

How soon you plan on retiring can factor into which type of annuity is best for your goals. If you have a shorter window, the stable accumulation of a fixed annuity may make the most sense. However, if you’re planning to continue working for a while, then the likelihood of increased accumulation from the high-power performance over more years will likely make more sense. 

What Is the Next Best Step? 

Annuities are a retirement planning tool. You can’t even take out money before age 59.5 (outside of some emergency cases), or the IRS imposes extremely harsh penalties. 

Give us a call at (858) 703-6178 with any questions. Our expert team can point you in the direction of what annuity may best fit your goals.