What is a Fixed Index Annuity?

With the current downward economic trend, investors seek new ways to grow their money for minimal risk. We suspect salespeople might try to fill that void with annuities. Though they grow slowly, annuities offer steady earnings with low risk.

Fixed index (aka fixed indexed or equity indexed) annuities are a low-risk option that offer higher potential returns than other types of annuity products.

While fixed index annuities have many benefits, they come with some rules, restrictions, and add-ons that can affect the way they work and the potential returns they offer.

They’re also complex and nuanced with many options and strategies available. As always, we suggest consulting with a financial professional to help make a decision that suits your needs and goals.

However, we still want to provide a broad overview of what fixed index annuities are, how they work, and the benefits they offer so you know what to look out for and how they might fit into your portfolio.

What is a fixed index annuity?

A fixed index annuity is a long-term investment sold by life insurance companies. However, they’re not considered insurance products. The annuity works as a contract between you and the insurance company, with potential earnings tied to the performance of a market index, such as the S&P 500.

Unlike a variable annuity (which invests in mutual funds), a fixed index annuity allows you to earn money based on the stock market without exposing it to the volatility of any actual stocks.

How do fixed index annuities work?

A fixed index annuity works like a call option. You buy the annuity from an insurance company. The insurance company uses that money to buy an option against a chosen market index. That option tracks the way the index changes between two points (a “term period”) and determines interest based on those changes. If the index’s value is higher at the end of the term than it was at the beginning, you can earn interest.

Simply put: You buy the annuity in hopes the index makes money. If the chosen index performs well, you earn interest.

For example, if the index has increased in value by 8%, you can (potentially) earn an 8% return. Stress on “potentially.”

How long are term periods?

Generally, a point-to-point term period lasts a year. However, your contract can last between 1-10 years or more. At the contract anniversary date, earnings are calculated and any interest credits back to your account. If your contract continues beyond that date, your annuity rolls on and a new term period begins.

Are there limits to my earnings?

The simple answer is, “it’s a low-risk investment, of course it comes with limits.”

The more complicated answer: there are specific types of limits and levers that apply to fixed index annuities. They each work differently. Your annuity might come with one of these limits or (more likely) a combination of some or all of them.

Keep in mind, the rates of these limits aren’t locked in. The insurance company can change these rates when your annuity renews on the contract anniversary date. They can do this without telling you or your financial advisor.


Caps put a hard ceiling on your earnings. They are the upper limit of what you can earn with that annuity, no matter how well the index performs.

For instance, suppose your annuity has an 8% cap. Even if the index grows by 12%, your returns are limited to 8%.

However, caps shouldn’t be confused with a guaranteed return. If your cap is 8% and the index grows by 6%, your potential returns are still only 6%.

Participation rates

Your participation rate is the percentage of total returns that could become yours. For instance, if you have a 100% participation rate, and your annuity earns 5% interest, you can earn the full 5%. If you have an 80% participation rate and it earns 5%, you earn 4%.


Spreads (or margins) are often referred to as fees. However, you don’t technically pay this fee. Instead, it comes out of your account automatically. Spreads are usually represented by a percentage that gets subtracted from the total returns. So, if your account earns 8% with a 2% spread, you could earn 6% (depending on the presence of other limits).

Hidden limit: dividends

When you look at the annual growth of an index, you might start seeing dollar signs. For instance, the S&P 500 averages about 10% growth per year. Even with your contract’s limits, that looks like guaranteed returns!

However, the index’s growth probably includes earned dividends. Fixed index annuities don’t count dividends when calculating growth. So, if dividends account for 50% of your index’s 10% growth, your potential returns are limited to 5%. And that’s BEFORE calculating caps, participation rates, and spreads.

When do these triggers apply?

Participation rates, caps, and spreads all come off of the total returns before they’re credited to your annuity.

For example, imagine your annuity has all three triggers. The index grows by 8%. You have a participation rate of 75%, a cap of 6%, and a spread of 2%. It might look like this:

With a 75% participation rate, your max interest 6%. This is great, because that matches your 6% cap!

Then, we subtract your 2% spread. The result: a 4% return is credited to your annuity.

Can I make withdrawals from my fixed index annuities?

Insurance companies rely on your money remaining in your account for the duration of your contract. To help ensure this, early withdrawals come with a penalty fee called a “surrender charge.” Surrenders are usually a percentage of your total annuity. Depending on your contract, the company might reduce the penalty the longer you go without making a withdrawal.

However, some annuities allow you to withdraw a certain percentage of your account before charging a surrender.

What are the benefits of fixed index annuities?

Despite their limits, fixed index annuities are good products that have many benefits. If these benefits are useful to you and your goals, these annuities might have a place in your portfolio. As always, a financial advisor can help determine which investments match your needs. Some of the most popular benefits of fixed index annuities include:

Tax-deferred growth

Fixed index annuity returns aren’t taxed until you withdraw them. Having tax-free interest build over the course of your contract can help your annuity grow bigger, faster.

Keep in mind that, when you eventually withdraw your earnings, you’ll need to pay taxes on them.

Premium protection

Fixed index annuities protect your initial investment (“premium”) against market losses. It does this by setting the bottom limit of point-to-point change at 0%. Even if the index shows overall losses during your term period, your annuity doesn’t lose money. While this can result in 0 earnings, it offers the potential for growth with very little risk.

Premium protection also prevents spreads from lowering your returns below 0%. So, if you have a spread of 2% and the index shows 0% growth, your earnings hold at 0%.

However, there’s one thing that can eat into your premium: fees. Though fixed income annuities rarely come with any fees themselves, the insurance company might offer add-ons (such as riders) that do.

It’s important to note that fixed index annuities are not insured by the FDIC. Therefore, the claims-paying ability of the issuing company can be impacted by unforeseen circumstances.

Guaranteed retirement income (with riders)

A lifetime income rider is something you attach to your fixed index annuity that can help supplement your retirement income to help ensure you have enough to retire. Once you “turn on” the rider, you can receive a certain percentage of your annuity in regular income payments every year. Several factors can affect how much income you can earn, such as the:

  • age at which you purchase the annuity
  • amount of your initial investment
  • age you wish to begin receiving payments

Because lifetime income riders must be attached to the annuity at the time of application, it’s typically a decision to make as you approach retirement. For instance, you might purchase the annuity with the rider at age 60 and turn on the rider at 65.

The specific percentage rate you receive depends on what the insurance company offers when you purchase the annuity. However, those rates are locked in for the life of the annuity. Any rate changes will only affect anyone purchasing a new annuity.