Indexed annuities, often called “equity-indexed,” “fixed-indexed annuities,” or “hybrid-annuities”, are a type of annuity that combines features from both fixed and variable annuities. “Hybrid” annuities are currently being heavily promoted as something quite new and different, but they are still just an indexed-annuity with income-for-life features built in (features attached to any annuity are called “riders“. Index annuities are generally pretty complex creatures, so make sure you’ve consulted with a financial advisor that you trust and ask him or her for explanations that you can understand before you commit to anything.

You may wish to familiarize yourself with our article on variable annuities, as indexed annuities have some similar features and sometimes similar risks (depending on the product and company being considered).

Indexed Annuities Explained

Indexed annuities are tax-deferred retirement vehicles and are designed for long-term retirement planning. They are not to be considered for short-term gain and you should only consider the purchase of one if you are already fully maximizing your IRA, 401k or other registered retirement plan. These annuities have components that are part traditional fixed annuity and part variable annuity, and the methods used to calculate the interest you may gain on this type of annuity can be very complicated. You can either make a single lump-sum payment or make payments over time to fund your indexed annuity for the accumulation phase. This may be a period of 5 years, or as long as 25 years, so make sure you are comfortable with the time-frame involved because there will likely be surrender fees if you change your mind.

The “fixed” aspect of an indexed annuity comes into play as the “income guarantee”. Currently the minimum guarantee one could get (this varies by State, so make sure you ask) is 87.5% of the total premium paid plus 1-3% interest each year the annuity is in place. Generally speaking, most indexed annuities offer what amounts to a “money-back” guarantee; you will get back at least as much as you put in, so your principal can be thought of as “safe.” The “variable” part of this annuity refers to the way in which increases in the value of your annuity are calculated. This is the tricky part because each insurance company may use a different system, but all indexed annuities have a few things in common. Your money is tied to the performance of a benchmark equity index, such as the S&P 500, and your gains are calculated based on the rise in that index in any given year. For example only, let’s say that the S&P 500 index is at 10,000 when you buy your annuity, and at the end of the year it has risen to 11,000. Simple math tells you that is a gain of 10%. Now you need to find out what your “participation” rate is “Participation rate: a fixed percentage of the total value of your annuity that is used to calculate gains (if any) in a given period”.

So, let’s say that you funded your annuity with a single premium of $100,000 (wise choice, this is probably the maximum amount that’s insured by your State), and your participation rate is 85%. That means that $85,000 is used to make the calculations. Next on the list, we need to know what “caps” (maximum amounts) might be in effect. Generally speaking, indexed annuities are capped at 8%. So now we have $85,000 * 8% = $6800. Lastly, we need to know what our insurance company wants to get paid in fees. This could be a fixed annual cost (unlikely) or (more likely) will be a percentage of the value of the annuity, possibly as much as 2% of the total value of the fund: $100,000 * 2% = $2000. Hey, we’re almost there now, let’s just do the last bit of math: your original gain = $6800, insurance companies fees = $2000; Therefore your annuity will have grown $4800. That’s 5.674% with the cap figured in, but only 4.8% interest on the actual value of your fund, which started at $100,000. In a most generalized way, we can probably get away with thinking that your indexed annuity will realize approximately half of any gain you see in the Index that you’re tied to.

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Factors to Consider

Surrender fees are typically included in an indexed-annuity contract and are fairly consistently applied by all insurance companies. As you are planning for long-term retirement, you shouldn’t have to worry about them too much, but it’s worth going over just in case you have an unforeseen emergency and need to access the funds in your account. On a 15 year policy, for example, you might be looking at up to 8 years in which withdrawals will be subject to surrender fees. Many of these policies allow an individual to take out a portion of any interest earned without penalty (normally after the first year), this will be defined by your contract, but anything above that amount will be subject to a fee (expressed in a percentage) if you are still within the “surrender fee” period. In the first 3 years, for example, you may have to pay 7% interest charges on amounts over $10,000. In the fourth year it would drop to 6% and will drop by a percentage point every year until it hits zero.

Taxes on indexed annuities are deferred until you start to draw upon the annuity. The IRS has a “FILO” (First In Last Out) policy when it comes to annuities, which simply means that the initials funds you FIRST put into the annuity are the LAST to come OUT of the policy. In real world terms this means that, even if you used after-tax dollars to fund the annuity, you will still pay tax on the money at normal income rates, and not lower capital gains rates, until any earnings the annuity has made have been exhausted. If you happen to be younger than 59 ½ years old you will also get dinged for an extra 10% by the IRS.

Who should buy an indexed annuity?

Let’s take a fictional couple, “Dick” and “Jane,” and make a few assumptions. Both are about to turn 50, and both are making the maximum allowable contributions to their 401k’s. They have $10,000 per year to invest, and they want to retire at age 60. Dick and Jane don’t have any kids, and they aren’t worried about leaving anything behind in their will. This is a couple that could probably really benefit from a 10 year differed-indexed annuity with income for life. For the first 10 years they are putting away their cash and their Index has returned solid 5% gains each year. Using our general rule of thumb, we’ll call it 2.5% or $2500 per year. Try out this Future Value Annuity Calculator if you would like to play with these numbers, but to skip to the end, let’s just say that you’ve made approximately $15,000. This doesn’t sound like much, but assuming you left your annuity alone and let the funds compound, you will have done about as well as a 10 CD (Certificate of Deposit) at current rates, but without plunking-down $100,000 up-front to do it. Now that Dick and Jane are 60 years old, they could decide to roll-over their 401k into their annuity and opt for an income-for-life annuity with a rider that keeps the payments coming until both have died. There is a great deal more to this, particularly when it comes to the math, but if their combined 401k’s are worth $500,000, plus they have their $115,00, then their lifetime payout could be as much as $5000 per month, or slightly less than that if they were to opt for their payouts to be adjusted for inflation each year. This is where the tax-deferred nature of an annuity really does become valuable, because if Dick and Jane are funding their retirement solely with the funds from the annuity then they are paying regular income tax on the money they draw each year, and their taxes will be lower than when they were earning a higher income.

For more information on annuities, check out our annuities guide.