What is an Indexed Annuity?

An indexed annuity is a special type of annuity, which is a contract made between an insurance company and a buyer that provides a guaranteed income, usually for life, to the payee, or annuitant. There's no requirement that the income begin immediately upon purchase, and in fact many annuities are deferred annuities – that is, they grow in value as part of a retirement planning portfolio, with the decision to convert to a guaranteed income – or annuitize – deferred until some point in the future. It's the method by which value accumulates that sets indexed annuities apart from all other annuities.

Most fixed annuities grow in value by earning interest at a rate declared annually by the issuing insurance company. An indexed annuity, though, is a type of fixed annuity in the US whose interest rate is linked to the performance of an equity market index such as the Standard and Poor's 500 (S&P500). The attraction of fixed annuities, including indexed annuities, is that there's no possibility for loss of principal. If the market index upon which an indexed annuity's interest rate is based declines during the measurement period, it simply earns no interest for that period. By contrast, if the stocks that a variable annuity's principal is invested in decline in value, the owner's account loses principal &emdash; a variable annuity has no downside protection.

If an indexed annuity's attraction is that its owner can participate in all the gains of the market without suffering any downside risk, an equally attractive feature is the “ratchet and reset” principal. This means that the baseline value of the index, against which gain or loss is calculated as a percent – is reset on the annuity's anniversary date. For instance, if a variable annuity's principal is invested in stocks worth $100,000 US Dollars (USD) on the purchase date, and those stocks lose 20% of their value in the first year, the annuity has lost $20,000 USD and is now worth $80,000 USD. If, in the second year, the stocks the variable annuity's principal is invested in gain 25%, or $20,000, at year's end, the variable annuity is worth $100,000 – exactly where it started.

Using the same figures for indexed annuities yield dramatically different results. The starting value is $100,000 USD, and at the end of the first year the underlying market index has lost 20% - say from 2,000 to 1,600. The indexed annuity's value still is $100,000 – no principal was lost because even though the interest rate is linked to market performance, the principal itself hasn't been invested in stocks, but at the end of the first year, the baseline for calculating the change in value of the market index is reset &emdash; now it's 1,600. In the second year, the market index increases by 25%, and finishes the second year right back where it started, at 2,000. The interest rate for the indexed annuity, linked to the index, is set at 25%, and the new value of the indexed annuity would be 25% higher than at the beginning of the year, or $125,000 USD. The same amount of money, and the same market – yet two different types of annuity, and two totally different results.

Of course, a volatile market can be highly unpredictable, and insurance companies will sometimes set limits on the interest rates paid by indexed annuities. A participation rate, for instance, determines what percentage of the market gain will be applied. A participation rate of 75% would mean that the 25% experienced by the market index in the example would translate to an interest rate of 18.75%, or $18,750 USD. Additionally, most insurance companies will also impose a cap on the interest rate indexed annuities can earn in any year. Prudent consumers considering an indexed annuity will ensure that the participation rate and interest cap are not so great that they'll render any market gain meaningless.

Like all other annuities, indexed annuities enjoy favorable tax treatment, with interest earned not subject to tax until actually paid out. By contrast, certificates of deposit, money market funds and other savings vehicles' interest earnings are taxable in the year that they're credited, thus diminishing their compounding power. On the other hand, when a beneficiary inherits any annuity upon the owner's death, even though probate is usually bypassed, income tax is immediately due on the entire tax-advantaged portion of the annuity – interest earnings and, if tax-qualified, principal as well. In many cases, this can push a beneficiary into a higher tax bracket, resulting in more taxes due than if the annuity had been annuitized or liquidated before the owner's death.