If you could predict the future, you’d have no problem investing all your money in the stock market, capturing all the upside and getting out right before any corrections. But without that crystal ball, you’re left making educated guesses, and even the sharpest investors inevitably get humbled by the market.

A fixed index annuity won’t deliver the best of both worlds, but it does provide a little bit of upside and lots of downside protection. By adding some market exposure, annuity owners can still take advantage of good years (like 2021 when the S&P 500 was up more than 25%) without taking on risk to their principal. However, fixed index annuities are complex financial instruments and retirement savers need to understand how they work before investing.

How Do Fixed Index Annuities Work?

Fixed index annuities are contracts offered by insurance providers. Fixed annuities work like long term bank CDs where a certain rate of return is guaranteed over the life of the contract. Payment can be made in a lump sum or in installments (known as the accumulation phase) and then funds are dispersed once the contract stipulations are met. Some annuities pay out right away, while others could spend decades in the accumulation phase.

But what about the “index” part? Fixed annuities have a set rate of return that won’t budge over the life of the contract. On the other hand, a fixed index annuity will offer some market exposure. Fixed index annuities offer two rates in a sense: a guaranteed base rate on your principal, and an extra return based on market performance.

Fixed index annuities are complex products because they attempt to combine two different rates of return. The calculation on how much weight the fixed and variable index rate applies to the principal can vary from firm to firm and even from contract to contract. Fixed and variable annuities have different mechanisms for producing returns, but the formula is fairly straightforward. Fixed index annuities require a little closer inspection to understand exactly how the returns are calculated.

Pros and Cons of Fixed Index Annuities

As with any financial product, fixed index annuities have benefits and drawbacks that must be considered. Consulting with a financial advisor is always a good idea before entering into any type of financial arrangement.

Pros

More Upside Than Fixed Annuities

Fixed index annuities allow retirement savers to capture some market growth without taking on uncomfortable levels of risk. By combining a fixed base rate with one that tracks an equity index, like the S&P 500 or Russell 2000, even those on fixed incomes can benefit from strong market returns.

Less Risky Than Variable Annuities and Index Funds

Yes, you can still lose principal in fixed index annuities, but the risk of such an occurrence is far less than that of a variable annuity or index fund. Variable annuities invest in a variety of mutual funds (known as sub-accounts) which rise and fall with the market. And index funds, while cost and tax-efficient, offer no downside protection. A fixed index annuity won’t produce returns as high as a variable annuity in a bull market, but it will also lose less in a bear market.

Favorable Tax Treatment

Unlike bank CDs, annuities aren’t hit with an annual tax bill for the interest. Interest earned by an annuity grows tax-free until the funds are dispersed, when presumably the annuity owner will be retired and in a lower tax bracket.

Cons

Not 100% Principal Protected

If the market suffers an extended decline, FINRA warns it’s still possible to lose money on your initial investment. For retirees on a strict fixed income, this could be a deal breaker, especially if a certain monthly payment threshold must be met. Annuities are generally safe products, but linking returns to equities inevitably invites some risk of principal loss.

Not FDIC Insured

One of the reasons that bank CDs are popular is they’re guaranteed up to $250,000 by the Federal Deposit Insurance Company. Annuities are regulated by the individual states in which the offering insurer resides, which provides some protection but not to the level of bank instruments.

However, annuities can be protected by the Guarantee Association in the event that an insurance company becomes insolvent. If that insolvent company cannot provide assets to you, the Association may pay your claim in full, up to the protection limitation. In South Carolina, state law limits protection to an aggregate of $300,000 for all policies, except major medical health policies which have a limit of $500,000. Each state has its own fun and limits are differ between each state, so be sure to review your policy and research your state’s protection limit.

Complexity

Annuities have a reputation of not being the simplest financial product to understand and the fixed index structure adds to the complexity. Buyers of fixed index annuities need to not only understand how stock indices work, but also the relationship between the fixed and index portions of the return rate. How much will stock underperformance drag down the account? What kind of losses would the annuity owner see in a drawdown of 20% or 30%? Make sure the insurance representative can explain the contract clearly and thoroughly.

Disclosures

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.

Fixed Index Annuities (FIA) are not suitable for all investors. FIAs permit investor to participate in only a stated percentage of an increase in an index (participation rate) and may impose a maximum annual account value percentage increase. FIAs typically do not allow for participation in dividends accumulated on the securities represented by the index. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Withdrawals prior to 59½ may result in an IRS penalty, and surrender charges may apply. Guarantees are based on the claims-paying ability of the issuing insurance company.