Indexed Annuities: The Good, the Bad, and the Truth

Goldfish with shark's fin swimming underwater
••• John Lund / Getty Images

Annuities, a financial product offered by insurance companies, can provide you with an income stream that you can't outlive. With many companies no longer providing pensions, annuities have become an appealing option to round out your financial plan. The only challenge is wading through the various annuity types and figuring out which one is best for you. An indexed annuity is one popular option, but you should review the terms carefully before buying one.

Indexed Annuities: The Good

Indexed annuities have characteristics of both fixed and variable annuities. Many indexed annuities have a minimum interest guarantee. This means that your principal is protected from market volatility, which more and more retirees have started to require. 

Indexed annuity returns are based on an index like the S&P 500. If the value of the index goes up, you receive a return based on that value. If the value of the index goes down, you typically receive a guaranteed minimum interest rate. The upside is limited, but the gains are permanently locked in on the contract anniversary date. That’s the value proposition for indexed annuities.

According to the SEC, some indexed annuities don't have a guaranteed interest rate, so it's important to review potential indexed annuities carefully and ensure you understand the terms and risks.

If you are comfortable with Certificate of Deposit (CD)-type returns, then indexed annuities could work well in the principal-protected part of your portfolio. To be clear, it is a contractual fact that an indexed annuity is not designed to take full advantage of the stock market. You don't receive dividends, and your participation rate limits your gains.

Your participation rate means you are credited with a percentage of the index's growth. If you have a 75% participation rate and the index grows by 7%, your indexed annuity will be credited 5.25% interest (7% × 75%). On the plus side, if the index drops by 5%, you may still receive a minimum guaranteed interest rate, depending on the terms of your annuity contract.

Indexed Annuities: The "Bad"

indexed annuities have a history of being oversimplified by the agents selling the products. The truth is that indexed annuities are complicated financial products. This doesn't mean that they're bad, but it does mean that you should review any potential annuity purchases carefully. If you have a trusted financial advisor, consult them before buying an indexed annuity.

You should also pay close attention to who is regulating the annuity. This depends on whether or not the annuity is considered a security. If it is, it's regulated by the SEC. If it's not a security, it's regulated by your state's insurance laws. Indexed annuity complaints should be directed to the appropriate regulatory group.

It's also important to know that you can lose money in an indexed annuity, even one with a minimum interest rate guarantee. This can happen if you withdraw money from your annuity early (before age 59 1/2) or if you surrender the annuity too soon. If you withdraw money too early, you may be hit with a tax penalty. If you surrender the annuity too soon, you may have to pay surrender charges. If some cases, you may be hit with a tax penalty and surrender charges. A good rule of thumb is to only put money into a deferred annuity that you don't expect to use any time soon.

Indexed Annuities: The Truth

Indexed annuities were first developed and designed to compete head-to-head with certificate of deposit (CD) returns, not the stock market. In other words, they weren't designed to earn a lot of interest; they were designed to earn a modest amount of interest that you can turn into a guaranteed income in the future.

You can also add an income rider to an indexed annuity for future income guarantees. In fact, this may be the best way to use indexed annuities. Don’t even look at the accumulation part (i.e., interest) of the policy in most cases. Focus on the income guarantees in your income rider. The reasoning is that you should always own annuities for what they will do for you, rather than what they might do. Contractual guarantees deliver.

You could also use indexed annuities in combination with fixed-rate annuities for laddering strategies. Some call this a “mixed-fixed ladder” because it’s a combination of fixed-rate and indexed annuities.

The bottom line is that indexed annuities are not too good to be true, but they can be pretty good if you keep your expectations in line with the contractual realities.