Moliciero Financial | Investing and Financial Planning

Understanding Indexed Annuities

Indexed annuities are a type of annuity that derives its value from the performance of an underlying index. There are indexed annuities that track a variety of indices, with the S&P 500, DJIA and Russell 1000 among the most common. Also called equity-indexed annuities, these are somewhat conservative investment vehicles for people who want guaranteed income in retirement, but also want to participate in stock market advances. Indexed annuities are seen as the best of both worlds when it comes to safe returns on investment, while still growing capital.

A History of Indexed Annuities

Indexed annuities were introduced in the 1990’s as an alternative to the standard fixed or variable annuities that were the norm. They gained in popularity as the bull market run in equities continued through the latter half of that decade. In 2004, sales of indexed annuities topped $25 billion and by the end of 2009 they approached $200 billion in annual sales. As baby boomers enter retirement age, the popularity of these instruments continues to grow.

Indexed annuities are considered somewhat conservative, because the money in these accounts seldom decreases. Most issuers of indexed annuities offer a guaranteed rate of return on an annual basis, regardless of the performance of the underlying index. This guaranteed payment is usually nominal, between 1% and 3%; but in years when the market performs poorly, the relative gain can be quite attractive.

Participation Rates, Spreads and Caps

In return for the promise of not losing money, issuers of this type of annuity generally pay only a percentage of the overall gain made by the index in winning years. This percentage is called the participation rate. In doing so, the issuer is able to reclaim losses from down years and in effect, smooth out returns over the long term. The participation rate for an indexed annuity is the multiplier for how much the account will gain, relative to its index. A participation rate of 70% means that if the index gains 10% for the year, the account will be credited 7% for that period.

Another method used by issuers of indexed annuities for paying returns that are less than the actual amount gained, is called a spread. The spread is the difference between what an index gains and what is credited to the annuity account. Typical spreads for indexed annuities range from 2% to 5%. So, in a year where the underlying index registers a 12% gain, the annuity holder can expect to receive between a 7% and 10% return.

In addition to the participation rate and spread, many issuers of indexed annuities place a cap on the gains that can be made in any annual earning period. This cap can be a fixed percentage, above which the issuer keeps all profit; or it can be a graduated range based on market performance. This type of interest cap protects an issuer in years of far greater than average returns in the index, and allows for payments to be made during down years. Typical fixed caps on an indexed annuity are between 6% and 9%. Graduated caps can be as high as 12% or greater during very good market years.

Tax Treatment of Indexed Annuities

The tax treatment of gains in an indexed annuity is identical to that of a fixed annuity. Taxes are deferred until the money is withdrawn from the account. Since annuities are typically meant to be used for retirement, the taxes paid when money is withdrawn will most likely be from within a lower tax bracket. Deferring taxes on earnings until retirement can be like earning an extra 1% to 3% on your money.

Some annuities allow for a small percentage to be withdrawn without fees from the issuer, but keep in mind that withdrawals made before age 59 ½ are still subject to penalties from the IRS. Excessive withdrawals made before the maturity date of the annuity are usually penalized with “surrender charges”. Many issuers of annuities however, allow for hardship withdrawals under certain circumstances. Withdrawals made that are related to nursing home expenses usually do not incur surrender charges or penalties by most issuers.

How to Buy Indexed Annuities

Indexed annuities can be purchased through making a lump sum payment, or through a series of scheduled payments. Making scheduled payments into an indexed annuity is the typical method for those planning to use the funds for retirement. The advantage of this type of participation is that when investment is made into the underlying index at regular intervals, the cost basis is normalized over time. By this method, an investor takes advantage of purchasing during both up and down periods, while participating in the overall advance of the stock index.

Some issuers of indexed annuities allow for a “death benefit” clause in the annuity contract. A death benefit will generally pay the estate of the decedent in the amount of all contributions made to that point, less any fees or withdrawals. Most issuers will require a certain number of years of participation before any death benefit kicks in.


Indexed annuities are a way to safely guarantee growth in a retirement account, while still participating in stock market advances. They have the advantage of being tax-deferred, with potentially higher rates of return than other annuity types. For someone planning for retirement and making regular contributions to an account, indexed annuities can be a wise choice. With many underlying indices to choose from and many options available, indexed annuities are well worth a look.