Indexed annuities: the basics

An indexed annuity (also known as a fixed indexed annuity or equity-indexed annuity) is a type of annuity that provides returns based on the performance of a specified market index, such as the S&P 500.

Key features include:

• Market-linked returns: Your returns are tied to the performance of a market index.
• Upside potential: You can benefit from market gains.
• Downside protection: Your principal is protected against market losses.
• Complexity: Indexed annuities are more complex than fixed annuities, with various moving parts.

How they work:

• You make a payment or series of payments to the insurance company.
• Your returns are calculated based on the performance of the chosen index.
• Gains are typically subject to caps, participation rates, or spreads.
• Your principal is protected if the index performs poorly.

Key differences between indexed and fixed annuities

Now that we’ve covered the basics, let’s dive into the key differences between these two types of annuities:

1. Return Calculation

Fixed annuity:

• Returns are based on a guaranteed fixed interest rate.
• The rate is set by the insurance company and remains constant for a specified period.

Indexed annuity:

• Returns are based on the performance of a market index.
• The actual return can vary from year to year, depending on market performance.
• Returns are usually subject to caps, participation rates, or spreads.

2. Potential for Returns

Fixed annuity:

• Offers steady, predictable returns.
• Generally provides lower returns compared to indexed annuities, especially in strong market conditions.

Indexed annuity:

• Offers the potential for higher returns, particularly when the linked index performs well.
• Returns can be higher than those of fixed annuities but lower than direct investment in the market.

3. Risk Level

Fixed annuity:

• Lower risk due to guaranteed returns.
• Not affected by market fluctuations.

Indexed annuity:

• Slightly higher risk than fixed annuities.
• Protected against market losses but may provide no returns in down years.

4. Complexity

Fixed annuity:

• Simple and straightforward.
• Easy to understand and predict returns.

Indexed annuity:

• More complex with various components (caps, participation rates, spreads).
• Can be more difficult to understand and compare between providers.

5. Flexibility

Fixed annuity:

• Less flexible, with set interest rates for specified periods.

Indexed annuity:

• More flexible, with the potential to benefit from market upswings.
• Often offers the ability to switch between indexed and fixed strategies.

6. Fees

Fixed Annuity:

• Generally have lower fees.
• Fees are typically built into the interest rate offered.

Indexed annuity:

• May have higher fees due to the more complex structure.
• Fees can include mortality and expense charges, administrative fees, and rider costs.

7. Suitability

Fixed annuity:

• Well-suited for conservative investors.
• Good for those prioritizing predictable income and principal protection.

Indexed annuity:

• Suitable for moderately conservative investors.
• Appealing to those seeking some market exposure with downside protection.

Pros and cons

Fixed annuities

Pros:

• Guaranteed, predictable returns
• Simplicity and ease of understanding
• Lower fees
• Principal protection

Cons:

• Lower potential returns
• Less flexibility
• May not keep pace with inflation

Indexed annuities

Pros:

• Potential for higher returns
• Downside protection
• Some participation in market gains
• More flexibility than fixed annuities

Cons:

• More complex structure
• Returns can be limited by caps, participation rates, or spreads
• Higher fees than fixed annuities
• Potential for no returns in down market years

Factors to consider

Some considerations to keep in mind when choosing between these types of annuities…

• Risk tolerance: Consider your comfort level with market-linked returns versus guaranteed fixed rates.
• Investment goals: Determine whether your priority is maximizing potential returns or ensuring steady, predictable income.
• Time horizon: Consider how long you plan to keep your money in the annuity before starting withdrawals.
• Market outlook: Your view on future market performance may influence your choice.
• Understanding of product: Ensure you fully understand the product you’re considering, especially for more complex indexed annuities.
• Financial situation: Consider your overall financial picture, including other investments and income sources.
• Fees: Compare the total costs associated with each type of annuity.

Tax implications

Both fixed and indexed annuities offer tax-deferred growth, meaning you don’t pay taxes on the earnings until you withdraw them. However, there are some tax considerations to keep in mind:

• Withdrawals before age 59½ may be subject to a 10% federal tax penalty.
• When you start receiving payments, the portion representing your original premium is not taxed, but the earnings are taxed as ordinary income.
• If you purchase an annuity with pre-tax dollars (e.g., within an IRA), all withdrawals will be fully taxable as ordinary income.

Regulation and consumer protection

Both fixed and indexed annuities are insurance products regulated by state insurance commissioners. However, indexed annuities have faced additional scrutiny due to their complexity:

• The SEC has implemented Rule 151A, which may classify some indexed annuities as securities, subjecting them to additional regulation.
• The National Association of Insurance Commissioners (NAIC) has established guidelines for the sale of indexed annuities to ensure consumer protection.

The takeaway

Choosing between an indexed annuity and a fixed annuity depends on your individual financial situation, goals, and risk tolerance. Fixed annuities offer the security of guaranteed returns and simplicity, making them suitable for conservative investors prioritizing predictable income. Indexed annuities, on the other hand, provide the potential for higher returns linked to market performance while still offering principal protection, appealing to those seeking a balance between growth potential and security.

Let Peachtree help

At Peachtree Financial Solutions, we’ve helped thousands of people get their money sooner by purchasing their future annuity payments for a lump sum of cash. Selling your payments is a regulated process and we have a lot of experience with these transactions. And while every annuity is unique, which means every payment sale will be different, they all have the same basic five steps:

• Call one of our representatives.
• Receive a free, no-obligation quote for the sale of your payments.
• Review and sign the purchase agreement.
• We process the agreement with your insurance company.
• You get your cash!

Why should you choose Peachtree?

It’s all part of something we call the Peachtree Promise: our experienced, dedicated representatives listen to your goals and clearly explain your available options. We meet you where you are without judgement and work hard to help you meet your financial goals. Getting your quote is completely free, and you’re under no obligation to sell to us if you aren’t completely satisfied with what you hear.