Fixed Index Annuity Pros and Cons
Annuities, particularly fixed index annuities, have become increasing popular the last two to three years. As a result, more insurance companies entering the index annuity marketplace and introducing new fixed index annuity products. The fact there are so many index annuity companies issuing products makes it more difficult to differentiate between individual index annuity contracts.
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 the advantages and disadvantages of a potential annuity purchase it’s best to have at least a working-understanding of what they are and how they 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 an Index Annuity?
Watch a Video: What is a fixed index annuity?
A fixed index annuity is a type of deferred fixed annuity that offers upside potential when the market performs and downside protection from potential market downturns. Rather than guarantee an annual interest rate like a fixed annuity (“CD-Type Annuity“), an indexed annuity credits interest based on the performance of an external market index (such as the S&P 500 ).
NOTE: You may also hear fixed index annuities referred to as:
- Equity Indexed Annuity
- Hybrid Annuity
- Indexed Annuity
Fixed Index Annuities have less risk than a variable annuity because you can’t lose value due to poor market performance. However, they have more risk than a fixed annuity because they come with a guaranteed interest rate; indexed annuities only guarantee the worst you can do in any given year is earn zero percent.
The below chart illustrates where a fixed index annuity falls between a fixed annuity and variable annuity as well as other investment vehicles on the investment continuum. Indexed annuities have increased in popularity largely because they offer the most growth potential of any investment that provides principal protection.
To be fair when sorting out the advantages and disadvantages of an indexed annuity, it is important to remember that these insurance products are retirement savings vehicle and not an investment. As such, they should not be compared to or expected to perform like an equity.
Rather, an index annuity should be compared to other savings vehicles that offer principal protection are a fixed annuity, Certificate of Deposit (CD) or cash.
How Does an Index Annuity 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.
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 if the market index decreases zero percent interest is credited for the year. The amount of the index performance your FIA is credited to is determined by the crediting method you’ve selected.
There are a couple of different index annuity crediting methods but Annual Point to Point is by far the most common so for time’s sake that’s the one we’ll focus on here.
Annual Point-to-Point Index Annuity Crediting Method
- Subtract the beginning index value from the index value at the end of the 12 month period.
- Divide the result, if positive (difference in annual values) by the beginning value
- The result is the market index performance.
Fixed Index Annuity Example:
- 107,000(ending value) minus 100,000(beginning value) = 7,000 positive change in index value.
7,000 (index value change) divided by 100,000(beginning index value) = 7% index performance.
- A crediting component, or limiting factor, is then applied to the index performance to determine your credited interest rate for the year.
Understanding How Index Annuities Credit Interest
The amount of annual interest credited to an Index Annuity is determined by applying a Spread, Cap, or Participation Rate to the annual performance of a specified stock market index.
Spread – The index performance minus the spread index annuity credited interest.
Cap – 100% of the index performance up to the cap is the index annuity credited interest.
Participation Rate – The index performance multiplied by the participation rate equals index annuity credited interest..
Assuming a 5.00% cap, 2.00% spread and a 75% participation rate let us calculate the amount of annual interest a fixed index annuity would be credited using the 7% index performance in our example above.
Cap = 5% Interest credited (100% of index performance up to the 5% cap)
Spread = 5% Interest credited (7% (index performance) minus a 2.00% spread)
Participation Rate = 5.25% Interest Credited (7% index performance multiplied by the 75% participation rate)
Uncapped Index Annuities
Allianz, AIG, and Athene have all been innovators in the indexed annuity space and I would attribute much of their success to that fact. Specifically, they all have uncapped crediting strategies and offer proprietary volatility managed indexes.
Traditionally, fixed index annuities only offered annual point to point with a cap as an interest crediting strategy. In recent years, the top annuity companies have begun to offer un-capped crediting strategies using a spread or participation rate. This means your upside potential is not capped so if the specified market index increased by 30% and your spread was 5% your index annuity would be credited with 25% interest.
Only because of volatility managed indexes is this possible. Unlike a static index such as the S&P 500 or the Russell 2000, a volatility managed index dynamically allocates between equities and fixed income based on volatility.
The ability to manage volatility within a market index smooths out returns over time and lowers the costs of the indexes options (annuity companies must purchase to back the indexed annuities they issue). A lower option cost enables insurer to purchase more options and in return, offer uncapped crediting options and more upside potential to their policyholders.
Best Uncapped Index Annuities & Market Indexes
I believe Allianz’s Bloomberg Universal Dynamic Index II, AIG’s Merrill Lynch Strategic Balanced Index, and Athene’s AiPex Dynamic Allocation Index are today’s the best un-capped index annuity options.
Annuity reviews for Allianz, Athene, and AIG products, as well as many others, can be found on our Annuity Reviews page. If you have questions regarding a specific index annuity or would like to request a personalized illustration you will find all of our contact information here.
Fixed Index Annuity Pros and Cons
Pros of an Fixed Index Annuity
#1. An Index Annuity Grows Tax-Deferred
Earnings within an annuity contract are tax deferred. This means you do not pay income taxes on the earnings until you withdraw gains from your account. Therefore, there are no annual 1099 forms to file or earned-interest entries to make on your 1040. Tax deferral also means that annuity earnings do not offset Social Security benefits as with earnings from bonds, CDs, and other investments.
#2. An Index Annuity Offers More Upside Potential Than Fixed Annuity
Fixed index annuities may credit higher interest rates than bank CDs or fixed interest rate deferred annuities.
#3. Index Annuities Have No Contribution Limit Like Traditional IRAs
Investors who have maximized contributions to their qualified retirement plans (i.e. 401k, IRAs, and pensions) are permitted to contribute without limit to a tax-deferred annuity.
#4. Index Annuities Can’t Loose Value Due to Market Volatility
When interest rates trend upward, annuity accounts are insulated from loss of principal; increasing interest rates often negatively impact government bonds and bond mutual funds. Unlike bonds which lose principal value during periods of rising interest rates, the account value of a fixed index annuity is guaranteed.
#5. A 401k Rollover into an Index Annuity is not Taxable
Annuities can offer valuable tax-savings for employees under the age of 59½ who receive large, lump-sum distributions from their 401(k) profit-sharing plans as part of an early retirement or severance package. Such amounts can be “rolled over” into an annuity policy without having to recognize taxable income.
#6. Indexed Annuities are RMD Friendly
Retirees over the age of 72½ are required to begin taking withdrawals from their IRA or Pension plans, known as Required Minimum Distributions (RMDs). The IRS penalty for not doing so is a substantial 50% of any amount that falls short of the Required Minimum Distribution.
#7. Index Annuities can Generate Guaranteed Lifetime Income
By “annuitizing” your IRA or fixed index annuity, you can exchange its value for an “immediate annuity” income stream in any of several forms (see earlier discussion on “Immediate Annuities”).
#8. Index Annuity Income Options are Flexible
#9. A Fixed Index Annuity Provides Legacy Benefit to Beneficiaries
Fixed Index Annuities pay full account value at death directly to your elected beneficiary avoiding probate.
#10. Index Annuity Account Values Lock-in Annually
Your indexed interest is credited to your fixed-indexed annuity at the end of each term. Any interest credited to your fixed-indexed annuity is locked in and protected from future market declines, “What Goes Up Doesn’t Have to Come Down.”
#11. Optional Riders are Available on Fixed Index Annuities
Some fixed indexed annuities offer optional riders such as living benefit riders (Long Term Care Riders) for guaranteed lifetime income or enhanced death benefits to aid with legacy planning.
#12. You Can Re-allocate Among Index Crediting Options Annually
When you purchase an indexed annuity you can spread your money amongst all of the available options or place it all into any of the available options. In addition, you have the ability to re-allocate among the available options each year your contract anniversary (typically a 30 day window at each anniversary).
Cons of a Fixed Index Annuity
#1. 10% IRS Penalty Applies to Index Annuity Withdrawals Prior to 59 1/2
Young investors beware. Like all annuities, the indexed variety incurs a 10% IRS tax penalty for premature withdrawals. All income withdrawals prior to the age of 59.5 are considered premature. Obviously a 10% penalty eats into earning substantially and should be avoided at all costs.
#2. Index Annuity Gains are Taxed as Ordinary Income Not Capital Gains
One of the downsides of annuity income is that it’s not considered a capital gain. When the capital gains rate is substantially lower than ordinary income taxes, annuity investors miss out.
“Tax Treatment of Income From an Annuity”¹ is a useful resource that highlights important tax factors to consider when selecting a product to support a retirement income plan.
#3. Optional Index Annuity Riders Cost a Fee
Index annuities present a tantalizing promise: stock market-style growth with none of the risk. Most insurers compensate by giving you a portion of the index’s raw growth, as opposed to the whole thing – this is done using one of the limiting factors described above.
Most fixed index annuities do not have a fee unless you elect to an optional rider.
#4. Surrender Charge Fees for Excess Index Annuity Withdrawals
Early withdrawal fees of 5-10% are common for any type of annuity. The important note is that these fees aren’t assessed for every withdraw. Your index annuity contract will spell out a maximum penalty-free amount that can be withdrawn on a yearly basis, usually 10% of your annuity contracts account value.
#5. Index Annuities Upside Potential is Limited by Crediting Factor
The upside potential is limited by some type of factor stated in the annuity contract. Usually the upside is limited by a spread, cap or participation rate. It is important to know that indexed annuities are not going to deliver equity type returns.
#6. Variety of Index Annuity Products and Features May Be Confusing
There are over 20 different insurance companies that offer fixed index annuities and more than 200 different fixed index annuity products on the market. It is important to select an index annuity designed to meet your specific goals.
7. Index Annuity Companies can usually change the interest crediting rates annually.
Best Index Annuity Rates
|Annuity Company||Fixed Index Annuity||Rating||Cap||Term|
|SILAC||Denali 14||B+||6.75||14 yrs|
|Sentinel Security Life||Accumulation Protector Plus w/ Rider||B++||6.00||10 yrs|
|SILAC||Denali 10||B+||5.50||10 yrs|
|Great American Life (GALIC)||American Legend 7 High Band||A+||5.25||7 yrs|
|SILAC||Denali 7||B+||5.00||7 yrs|
|Guaranty Income Life||WealthChoice 7||B++||5.00||7 yrs|
|Great American Life (GALIC)||American Legend 7 Low Band||A+||5.00||7 yrs|
|Fidelity & Guaranty Life||Prosperity Elite 10 Protection||A-||5.00||10 yrs|
|Fidelity & Guaranty Life||Prosperity Elite 7 Enhancement||A-||5.00||7 yrs|
|American National (ANICO)||Strategy Indexed Annuity PLUS 10||A||5.00||10 yrs|
|Sentinel Security Life||Accumulation Protector Plus||B++||4.80||10 yrs|
|SILAC||Teton 10||B+||4.75||10 yrs|
|Great American Life (GALIC)||American Legend 7 Non-MVA High Band||A+||4.75||7 yrs|
|Guaranty Income Life||WealthChoice 5||B++||4.50||5 yrs|
|American Equity||IncomeShield 7||A-||4.50||7 yrs|
|Oxford Life Insurance||Select 10||A-||4.50||10 yrs|
|Nassau Life and Annuity||Nassau Growth Annuity 10 Group B||B+||4.50||10 yrs|
|American General Life Insurance||Power 10 Protector High Band||A||4.50||10 yrs|
|American General Life Insurance||Power 7 Protector High Band||A||4.40||7 yrs|
|Great American Life (GALIC)||American Landmark 5 High Band||A+||4.30||5 yrs|
|American General Life Insurance||Power 5 Protector High Band||A||4.30||5 yrs|
|Guggenheim Life and Annuity||Highlander 7||B++||4.25||7 yrs|
|Guggenheim Life and Annuity||ViStar||B++||4.25||10 yrs|
|EquiTrust Life Insurance Company||Market Value Index||B++||4.25||10 yrs|
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. VA sales decreased from approximately $185 Billion in 2006 to ~$100 Billion in 2020 while FIA sales increased from ~$75 Billion to ~$120 Billion during the same timeframe.
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 associate with variable annuities vs. low or no fees of an index annuity.
Typical Variable Annuity Fees
- M&E (mortality and expense) – average around .50%
- Sub-Account Fees – average 1.00%
- Optional Rider Fees (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.
An indexed annuity’s credited interest is calculated annually and determined by the performance of a stock market index. However, you are not directly invested in the market which means your index annuity account value won’t decrease due to a potential market downturn.
Is an Index Annuity Right for You?
In addition to the advantages and disadvantages above, below are some helpful guidelines to help you 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, but want to reduce the risk in your portfolio
- You want a generate a steady stream of guaranteed retirement income
- You want the chance to earn more interest than available using a fixed annuity or CD but still want principal protection from market loss
- 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 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 attempt to make up for lost time with higher gains.
Frequently Asked Questions
You may reallocate available funds at the end of each crediting period on your contract anniversary. You have 30 days to submit a re-allocation form - if you do not, your allocations will remain the same as the previous year.
It is important to note that a fixed index annuity is an insurance contract issued by an insurance company and is not a security. As such, they will not generate equity-like returns. They are a good retirement savings vehicle that provides a safe and steady way to grow your retirement savings.
Fixed Index Annuities do not have any fees in general; however, there are optional income riders, long term care riders, and death benefit riders that can be added to an index annuity for a fee.
You can not lose money in an indexed annuity due to a potential market downturn. However, indexed annuities do have surrender penalties if you withdraw your money prior to the end of your contract. In addition, withdrawals prior to age 59 1/2 may be subject to a 10% IRS tax penalty.
Gains are limited by a crediting method or "limiting factor", index annuity contracts can be complex, contracts vary greatly from insurance company to company, highly customizable, surrender penalties for withdrawals above the annual free withdrawal provision, pre 591/2 tax penalties, and crediting factors can change on the contract anniversary date.
An Uncapped Fixed Index Annuity refers to an indexed annuity with a crediting method that does not cap the interest your account can be credited in any given year. Instead of a cap, uncapped options use a spread or participation rate crediting method.
- Dobler, Jim. “Tax Treatment of Income from an Annuity.” NAFA Annuity Outlook, November/ December 2013.
- “Fixed Indexed Annuities 101.” Indexed Annuity Leadership Council.