What is a fixed index annuity?

If you are already retired, or you still have several years before retirement, you should consider investing in products that protect your money and provide growth potential. Since stocks carry more risk, you can consider investing in a fixed index annuity, which provides both protection and the opportunity to grow your money. 

A fixed index annuity (FIA) is a contract between an insurance company and an investor in which the insurer agrees to make periodic payments to the investor, usually beginning immediately and continuing for the rest of the investor's life. The payments are based on a percentage of the value of a set underlying index, such as the Standard & Poor's 500 Index. Unlike a variable annuity, a fixed index annuity protects your money from stock market volatility. 

How does a fixed index annuity work?

When you invest in a fixed index annuity, you will earn interest in two ways, also known as crediting strategies. The strategy with the lowest risk is the "fixed" part of the annuity, which pays a fixed interest rate over a specific period, after which the rate resets but never falls below the minimum guaranteed rate.

The other strategy offers more upside, and it is the “index” side of the annuity. You will earn interest based on the performance of an index such as the S&P 500, but the rates have restrictions around them. Usually, the insurance companies offering the fixed index annuity provide a 0% floor, meaning that the worst your money can do is to stay the same and not fall below 0%.

Insurance companies may also provide rate caps and participation rates. Rate caps refer to the maximum return you can earn on your annuity. For example, if your annuity contract has a 6% rate cap, and the index annuity earns a 10% return, the maximum you can get is a 6% return. On the other hand, if the annuity contract has a participation rate, you will receive a percentage of the growth that the index earns. If the annuity has a 50% participation rate, and the index earns a 10% return, you will get 5% in return. 

How to invest in a fixed index annuity

The first step when investing in a fixed index annuity is to contact the annuity issuer. The issuer will ask you to provide them with some basic information, such as your age and how much money you want to invest. The issuer will then provide you with a contract that explains the terms of your annuity.

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If you buy the annuity contract, you will be required to transfer funds to the annuity contract and then choose the index to invest in. You can transfer funds as a lump sum payment, make smaller payments over a period, or transfer funds from your retirement account. You can choose to invest the funds in a single index, or spread the funds across several indexes.

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When buying a fixed index annuity, you should review the contract terms to understand its risks and rewards. If you have any questions, be sure to ask the issuer before signing the contract.

How to withdraw money from a fixed index annuity

If you want to withdraw money from a fixed index annuity, you will need to contact the insurance company or financial institution that issued the annuity. The company will tell you how much money you can withdraw and when you can do so. Typically, you will need to pay a surrender fee if you withdraw money from the annuity before a certain period of time, such as five or seven years.

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When taking withdrawals from a fixed index annuity, it’s important to remember that you may owe taxes on the money you withdraw. Additionally, if you withdraw money before you turn 59 ½, you may also be subject to a 10% early withdrawal penalty from the IRS.

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Before taking any money out of a fixed index annuity, consider the impact it will have on your retirement funds. 

Fixed index annuity fees

There are several types of fees that are associated with fixed index annuities. Some of the fees you can expect to pay include:

Surrender charges

If you cancel or withdraw funds from your account in the initial years of your fixed index annuity, you should expect to pay a surrender charge. This fee reduces the value and return of the annuity contract.

Administration fee

The fixed index annuity will charge an annual administration fee each year, usually as a percentage of the annuity contract value.

Mortality expenses

This fee is charged by the insurance company providing the annuity, and it covers the insurance costs and the expected cost for future income guarantees.

Rider fees

When you buy an annuity, you can choose to purchase riders to provide extra benefits for the contract. You will pay a fee for each rider, and it can be a one-time fee or a monthly charge. 

Pros of fixed index annuities

Some of the pros of fixed index annuities include:

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Guaranteed income: A fixed index annuity can provide a guaranteed stream of income, which can be helpful in retirement.

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Interest earnings: The interest earned on a fixed index annuity is typically higher than what you would receive from a traditional savings account or certificate of deposit.

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Flexibility: A fixed index annuity offers some flexibility in terms of when you can withdraw money and how you can use the funds.

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Protection from market volatility: Because your money is invested in a fixed index annuity, it is not as susceptible to stock market volatility as money that is invested directly in stocks.

Cons of fixed index annuities

Lack of liquidity: Unlike with a traditional savings account or CD, you may not be able to access your money right away if you need it. This can be a problem if you need to make a sudden large purchase or if you experience an unexpected expense.

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Fees: There may be fees associated with a fixed index annuity, such as administration fees and surrender fees.

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Risk: With return rate caps and participation rates, there is some uncertainty over how much return you will earn each year with a fixed index annuity. 

Fixed index annuity vs. variable index annuity

The main difference between a fixed index annuity and a variable index annuity is the upside potential and market volatility protection.

A variable annuity puts your money in the stock market, and you will get the full market return, both good and bad. If the market performs well, you can potentially earn more returns with a variable annuity, but you could also lose significantly more with a variable annuity if the investments perform poorly.

In comparison, a fixed index annuity may be better if you want to get stock market exposure but you want to avoid the potential for large losses.

Fixed index annuity vs. fixed annuity

A fixed annuity offers a guaranteed rate of return, but unlike a fixed index annuity, it does not invest money in the stock market. Since it pays you a set guaranteed rate of return, you will know how much your retirement savings will grow when you sign up the contract. However, in the long term, you could earn a lower return than what a fixed index annuity would earn. Therefore, a fixed annuity may be better for short-term investment timelines, while a fixed index annuity may be better for long-term investments.

Should you buy a fixed index annuity?

A fixed index annuity may be a good option if you are looking for a guaranteed stream of income in retirement. The interest earned on these annuities is typically higher than what you would receive from a traditional savings account or CD, and your money is not as susceptible to stock market volatility as money that is invested directly in stocks.

However, there are some drawbacks to consider before purchasing a fixed index annuity, including the lack of liquidity and the potential for fees. You will also need to pay taxes on the interest earned from these annuities.