Fixed Index Annuity Pros and Cons
Fixed index annuities, sometimes referred to as equity indexed annuities, have become increasingly popular in recent years. As a result, more annuity companies are now issuing index annuity contracts.
This has made it more difficult for consumers to decide which index annuity product is best for them.
In this guide, we’ll cover all of the fixed index annuity pros and cons in detail. I’ll also walk through the different features offered in a fixed index annuity and explain what options to look for based on your individual goals and objectives.
In this guide to the pros and cons of a fixed index annuity we’ll cover:
Like all major decisions in life, it is best to consider the pros and cons of a fixed index annuity prior to making any purchasing decisions.
However, before evaluating any single specific annuity contract it’s best to have at least a working understanding of how indexed annuities work.
As such, before we compare and contrast index annuity pros and cons we’ll begin with what an indexed annuity is and how they work.
If you are already up to speed with fixed index annuities, you may prefer to jump directly to fixed index annuity pros and cons.
What is a Fixed Index Annuity?
Watch a Video: What is a fixed index annuity? (3 mins 51 seconds)
A primary benefit is you get upside potential when the market performs and your money is protected from a potential stock market crash. The trade-off is they don’t provide guaranteed annuity rates like many other annuity contracts.
One of the top indexed annuity pitfalls on our list of index annuity pros and cons is they do not provide you a guaranteed annuity rate like a multi year guaranteed annuity contract does.
On the flip side, of the many annuity contracts index annuities provide the best possible annuity growth of any fixed annuity type.
In fact, an indexed annuity has the most upside potential of all retirement investment options offering principal protection.
The below chart illustrates where they fall on the investment continuum.
To be fair when sorting out the advantages and disadvantages of an indexed annuity, it is important to remember that these are insurance products so you should not expect equity-like returns.
Since indexed annuities are a type of fixed annuity they protect your money from a potential stock market crash. This makes CDs and fixed annuities the indexed annuities alternatives.
How Do Indexed Annuities Work?
Index annuities earn interest-based, in part, on the positive performance of an external stock market index, such as the S&P 500®. Interest is credited to an index annuity on each contract anniversary and is guaranteed to never be less than zero percent.
Stock Market Indexes available in an indexed annuity
At each annual contract anniversary, the performance of the specified market index is measured. If the index performs (increases in value) the index annuity is automatically credited interest and earns zero percent interest in years that the index goes down.
Fixed Index Annuity vs Variable Annuity
The line graph below compares the sales of variable annuities (VA) and fixed index annuities (FIA) in the United States from 2006 to 2020. Variable annuities are represented by the blue line while the red line represents indexed annuity sales.
As you can see, variable annuities have decreased in popularity significantly while fixed index annuities are becoming increasingly popular. This is partly because variable annuities have more fees than any other annuity type.
Variable annuity sales have decreased from approximately $185 Billion in 2006 to ~$100 Billion in 2020. Equity indexed annuities increased from ~$75 Billion to ~$120 Billion in sales.
2016 marked the first year that individual fixed index annuity sales surpassed variable annuity sales in the United States. This is due in large part to the high cost and fees associated with variable annuities vs. low or no fees of an index annuity.
Typical Variable Annuity Product Fees
- M&E (mortality and expense) – average around .50%
- Sub-Account Fees – average 1.00%
- Optional Rider Fees (annuity income rider or death benefit rider) – Average 1.00% each
If you are considering purchasing a variable annuity you will find the U.S. Securities and Exchange Commission’s (SEC) Variable Annuities: What You Should Know investor tips.
Pros and Cons of a Fixed Index Annuity
Advantages of a Fixed Index Annuity
- Index annuity account balances are “locked-in” annually.
- May provide a better rate of return than other investments with principal protection.
- Annuity investors are able to grow their retirement savings tax-deferred.
- An index annuity yields a better rate of return when the stock market performs.
- Optional lifetime annuity income riders are available on many index annuity products.
- Backed by state-regulated insurance companies with strong financial ratings.
- You can make unlimited contributions; unlike an IRA or 401(k).
Fixed Index Annuity Disadvantages
- 10% IRS Penalty Applies to Index Annuity Withdrawals Prior to 59 1/2
- Fixed Index Annuity gains are taxed as ordinary income, not the lower capital gains tax rate like many other investments.
- Some of the optional annuity income riders come with annuity fees charged as a percent of your account annually.
- Indexed annuities come with charge a fee on withdrawals above the free withdrawal amount (so do many annuity contracts).
- The interest you can earn in an Index Annuity is limited by an index annuity crediting method so there is less upside potential than riskier investment options.
- The vast variety of Index Annuity products and features can be confusing and at times seem overwhelming.
- Annuity Companies can your annuity’s interest crediting rates at each contract anniversary.
Is an Index Annuity Right for You?
There are multiple annuity products so I wanted to wrap up my fixed index annuity pros and cons guide with some helpful tips on how to decide if a fixed index annuity may be a good investment for you.
An Index Annuity may be right for you if…
- You have a retirement plan in place with equity components, but want to diversify with low-risk annuities.
- You want a generate a steady stream of guaranteed annuity income.
- You want the chance to earn more interest than you would if you bought another type of fixed annuity product.
- You have maxed out your 401(k) and traditional IRA’s and want to contribute more to tax-deferred investments.
- You are approaching or already retired and need to minimize the sequence of returns risk.
An Index Annuity may not be right for you if…
- You are very comfortable with risk and fluctuations in your portfolio balance
- You have already incorporated enough fixed income solutions that hedge against market volatility into your retirement portfolio.
- You anticipate you may need to the cash in your annuity before the full term of the contract or before you reach age 59 1/2.
- You are behind on your retirement savings and really need to invest in riskier assets in an attempt to make up for lost time with higher gains.
Frequently Asked Index Annuity Questions
You can not lose money in a fixed index annuity even if the stock market crashes because your money is not invested directly in the stock market. An index annuity earns interest based on the performance of a stock market index but zero percent is the worst your annuity can do in any given year.
Fixed index annuities are a good retirement savings vehicle for a conservative investor who wants to keep their principal protected but also would like a chance to earn more interest than a fixed annuity or CD will guarantee.