A fixed annuity is a type of insurance contract that promises to credit the buyer earnings at a specified, guaranteed interest rate on their contributions to the account. These financial products are often used in retirement planning.

How Does a Fixed Indexed Annuity Work?

A fixed indexed annuity (FIA) is a contract between you and an insurance company in which the insurer agrees to provide a series of steady payments, either immediately or in the future, based on the performance of an underlying stock market index, such as the S&P 500, Nasdaq Composite, or Russell 2000.¹ You can purchase an annuity by making a single payment or a series of payments. Similarly, your payout can be a single payment or a series of payments over time. Unlike index funds, fixed indexed annuities generally protect against loss of principal. This means you will not lose any of the money you invested in a fixed indexed annuity. However, this protection against losses comes at a cost. You will not receive the exact return of the market index. Instead, the annuity limits both your potential gains and your losses. This makes an indexed annuity less risky, although it may charge higher costs than an index fund.

How to Invest in a Fixed Indexed Annuity

To set up a fixed indexed annuity, you must first purchase an annuity contract. You can make a single payment, or 'lump sum,' transfer funds from a retirement plan, or make multiple payments over time. You then tell the annuity company how to invest the money. The insurance company, in turn, guarantees that the account will earn a specified interest rate. This period is known as the accumulation phase. You can allocate all your money to one index or divide it among several. Your returns depend on the performance of the market indexes you choose.

When the annuity owner, or annuitant, chooses to begin receiving regular income from the annuity, the insurance company calculates those payments based on the amount of money in the account, the owner's age, how long payments will continue, and other factors. This begins the payout phase. The payout phase can continue for a specified number of years or for the rest of the owner's life.

During the accumulation phase, the account grows on a tax-deferred basis. When the account owner annuitizes the contract, distributions are taxed according to an exclusion ratio. This is the ratio between the account owner's premium payments and the amount accumulated in the account based on interest earnings during the accumulation phase. Premiums paid are excluded, and the portion attributable to earnings is taxed. This is often expressed as a percentage.²

This situation applies to nonqualified annuities, which are those not held in a qualified retirement plan. For a qualified annuity, the entire payment would be taxable.

Fixed Indexed Annuity Fees

Fixed indexed annuities do not charge an upfront fee. The annuity company deducts its fees from your account balance each year. Some possible charges include:

• Return limits. In years when your market index performs strongly, the annuity company keeps a portion according to the terms of your contract.
• Mortality expenses. Also known as M&E fees, these cover the annuity company's expected cost of its future income guarantees. They also cover the company's costs of selling the contract.
• Administrative fee. The fixed indexed annuity may charge an additional administrative fee each year.
• Riders. When you sign up for an annuity, you can choose to purchase riders that provide additional benefits under the contract. For example, you could purchase one guaranteeing a minimum return over the life of the contract. You pay an annual fee for each rider.
• Surrender charge. You must pay a fee called a surrender charge if you cancel the contract or make a lump-sum withdrawal during the first few years of your fixed indexed annuity.

Advantages of a Fixed Indexed Annuity

• Limits on losses. During major market downturns, you do not have to worry about substantial losses with a fixed indexed annuity.
• Possible guarantees on earnings. An indexed annuity may pay a guaranteed minimum return even when the market index loses money. It may also lock in your gains over time to protect you from even greater losses.
• Inflation protection. The expected long-term return on a fixed indexed annuity is higher than that of other guaranteed accounts, such as a fixed annuity or certificate of deposit (CD). This can help your earnings outpace inflation.
• Tax-deferred growth. An annuity postpones taxes on your earnings until you withdraw the money, much like an individual retirement account (IRA) or 401(k). This can help increase your after-tax return compared with similar money held in a regular brokerage account. However, this tax-advantaged status also exposes you to a 10% penalty if you need to withdraw from your annuity before age 59½.²

Disadvantages of a Fixed Indexed Annuity

• Limits on potential gains. Fixed indexed annuities limit your upside, so you do not earn as much in good years as you would by investing directly in the market.
• High fees. Between annuity fees and the cap on earnings, you could end up paying a substantial portion of your earnings to the annuity company each year.
• Surrender charges. If you cancel your contract before the surrender period ends, you could owe the annuity company a significant fee.
• Some uncertainty about returns. Even with loss limits and minimum-return features, there is still some uncertainty about how much you will earn each year with a fixed indexed annuity.

Is a Fixed Indexed Annuity Right for Me?

If you are investing for the medium or long term and want some market exposure with less risk, a fixed indexed annuity could be a good compromise. Your potential long-term return is higher than if you kept all your money in a guaranteed account, such as a fixed annuity or certificate of deposit. At the same time, you do not have to worry about a steep market loss. You should consider the time, effort, and risk involved in investing—generally, the worst outcome is losing your money or the time you invested—whether you start a business or put your money into a stock market index. The guarantees an annuity provides come at a cost, so be sure to weigh the trade-off between limits on earnings and annuity fees. Consider speaking with a financial advisor before signing up for a fixed indexed annuity.

Sources and References for This Article

[1]  https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/annuities Accessed October 10, 2022 [2] Internal Revenue Service. "Publication 575 (2019), Pension and Annuity Income." Accessed October 11, 2021 [3] Internal Revenue Service. "Topic No. 558, Additional Tax on Early Distributions from Retirement Plans Other Than IRAs." Accessed October 10, 2022.