How Does an Indexed Annuity Differ From a Fixed Annuity?
Written by
Jacob Wade
Edited by
Melanie Grafil
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An annuity offers guaranteed income for a set period. There are several types of annuities to choose from, with fixed annuities and indexed annuities being two of the most popular options. While both provide steady income, each offers a different approach to providing income and growth.
Here’s an overview of how fixed annuities and indexed annuities work, the pros and cons of each and when to choose one over the other.
Indexed Annuity vs. Fixed Annuity
An indexed annuity gains value when the market performs well, making it somewhat higher risk than a fixed annuity. A fixed annuity, on the other hand, offers growth at a guaranteed interest rate. The returns can be lower with a fixed annuity, but the earnings are steady and predictable.
A fixed annuity may be a better choice for risk-averse investors who want more stability and prefer few, if any, surprises. For investors who can handle a bit more risk in exchange for the potential to see higher returns, an indexed annuity could be a better choice.
What Are the Differences Between Indexed and Fixed Annuities?
Here’s what you should know about the two annuity types.
Growth Potential
While both fixed and indexed annuities offer tax-deferred growth, downside protection of your principal investment and add-ons such as riders and death benefits, there are differences in how they approach investments.
Risk Level
Fixed annuities are considered lower risk since the rate is “fixed,” and thus, you’ll be guaranteed a return on your investment. Your money is effectively safe in the event of a downturn.
On the other hand, indexed annuities are a bit riskier since their growth depends on how well the market is performing. However, there is still a minimum guaranteed return, even if there’s a downturn.
Flexibility and Complexity
Fixed annuities offer guaranteed income and a fixed interest rate, typically based on prevailing interest rates. However, indexed annuities offer growth by tracking a market index and sharing some of that growth with you.
Suitability for Investors
Fixed annuities always pay out some interest, even after the fixed rate period ends. While indexed annuities protect you from losing money, you might end up not earning anything during years when the market is down.
| Feature | Fixed Annuity | Indexed Annuity |
|---|---|---|
| Return source | Guaranteed fixed interest rate | Based on a market index with a guaranteed minimum |
| Growth potential | Lower, but steady and predictable | Higher potential, but capped |
| Risk level | Low – not affected by market downturns | Moderate – tied to market performance but has protection in a market downturn |
| Loss protection | Yes, your initial investment is guaranteed | Yes – your initial investment is protected even if the market has a downturn |
| Best for | Ideal for conservative, risk-averse investors | Better for investors willing to accept some risk for potentially higher returns |
| User experience | Straightforward | More complex (includes caps, participation rates) |
What Is a Fixed Annuity?
Fixed annuities offer a guaranteed minimum interest rate and a fixed number of payments over a set period.
Features
Fixed annuities are similar to other types of fixed-income investments, such as certificates of deposit or U.S. Treasuries. You choose an interest rate and payout term, and receive payments based on your chosen terms. Fixed annuities are regulated by state commissioners.
There are two types of fixed annuities: immediate annuities and deferred annuities.
Immediate Fixed Annuity
An immediate annuity starts paying you right away. It’s usually funded with a lump-sum payment up front, in other words, a single premium. These annuities let you choose your payment term, such as a set number of years or “lifetime,” and provide a guaranteed minimum interest rate for the life of the annuity.
Deferred Fixed Annuity
A deferred fixed annuity allows you to pay lump-sum or monthly premiums into the annuity and has a set interest rate for a fixed amount of time, usually one to seven years. After the guaranteed interest period, the annuity will pay out a set minimum interest rate until the contract matures, usually after reaching an advanced age, such as at the age of 100, or after your lifetime. You typically don’t draw from a deferred annuity until a later date.
Pros and Cons of Fixed Annuities
Fixed annuities are a good investment for some, but might not fit the bill for others. Like any investment, there are upsides and downsides to consider. Here are a few pros and cons of fixed annuities:
Pros
- Guaranteed income in retirement
- Guaranteed minimum interest rate
- Grows tax-free until payments start
- Potential death benefits for beneficiaries, if you pass away before payouts begin
Cons
- Locked-in interest rate
- May not keep up with inflation
- The fixed rate is only locked in for a few years.
Fixed annuities offer steady payouts and a guaranteed minimum return on your money. This is ideal for those close to retirement, or those who are currently retired and want a dependable, guaranteed source of income.
Fixed annuities also use actuarial tables to project your life span. If you outlive your projected lifetime, a lifetime fixed annuity will continue paying out, making it a good way to guarantee there is income coming in if you live longer than expected.
If you choose a deferred fixed annuity, you are also protected from income taxes while your annuity grows in value. This can help you defer taxes until much later when you start receiving payments from the annuity.
Who Should Choose a Fixed Annuity?
Both fixed and indexed annuities offer income for retirement with some tax advantages and investment protection. However, choosing one over the other depends on your investment goals, risk tolerance and other factors.
Fixed annuities are ideal for retirees who want a simple fixed-rate return on their money with a guaranteed payout for their lifetime. Whether you choose an immediate or deferred fixed annuity, you can count on the money being there month after month.
What Is an Indexed Annuity?
Indexed annuities are a hybrid investment and insurance product that offers investment returns based on a market index, such as the S&P 500. Indexed annuities allow investors to participate in some of the upside of a particular market while limiting the downside risk.
Features
Most indexed annuities offer a minimum guaranteed return, even if the market index is performing terribly. This minimum may protect only your principal investment, which means a zero percent return. However, you won’t lose any money.
Indexed annuities typically cap the upside as well. If there’s a 10% annual cap, for example, and the S&P 500 returns 25% during the year, you’ll only earn a 10% return.
Indexed annuities also have a “participation rate,” which is the amount of market return you have access to. If your indexed annuity has a 75% participation rate, for example, and the index it tracks returns 10%, you would get a 7.5% return.
Pros and Cons of Indexed Annuities
Indexed annuities offer guaranteed income and potential growth of your principal investment based on market index returns. There are a few downsides to consider as well, before buying one. Here are the pros and cons of indexed annuities:
Pros
- Returns track a market index, such as the S&P 500
- May earn more than a fixed annuity
- Growth is tax-deferred until retirement
- Downside guarantee protects your principal investment
Cons
- Provides lower returns than directly investing in a market index fund
- Upside is usually capped
- May earn 0% returns during market downturns.
Indexed annuities allow you to potentially earn a higher return than other annuities based on market performance. This can help grow your money faster than with a fixed annuity.
Plus, most indexed annuities don’t allow you to lose money. The downside protects your invested capital, making it a lower-risk product than investing directly in the market.
Like other annuities, you can defer taxes on indexed annuities until you begin receiving payouts.
Who Should Choose an Indexed Annuity?
Indexed annuities are better for investors who want to take advantage of the growth in a market index without the downside of potentially losing money. While the growth is capped, indexed annuities have the potential of earning more than a fixed annuity; they may also return nothing when the market index is down.
Overall, annuities may fill a specific need in your financial plan, and choosing one that fits your larger retirement planning needs can help offset some investment risk and protect your income in retirement. They can be complicated, however, and can come with extra fees and options that could offset any of the positives. It’s a good idea to work with a licensed financial planner to help you choose one that works for your retirement goals.
Fixed Annuity vs. Indexed Annuity FAQ
Here are some answers to frequently asked questions about the differences between a fixed annuity and an indexed annuity.- What is the main difference between indexed and fixed annuities?
- The main difference between an indexed and a fixed annuity is how each grows your investment. A fixed annuity has a guaranteed interest rate, thus a guaranteed return. An indexed annuity is tied to market performance, which means that how much you earn will vary, though it's still safe from any losses if there is a downturn.
- Are indexed annuities riskier than fixed annuities?
- Indexed annuities are inherently riskier than fixed annuities because they are dependent on stock market performance. However, you are still guaranteed a minimum return, so you won’t lose out on your investment.
- How do return caps work in indexed annuities?
- Return caps limit just how much in returns you’ll earn from your fund’s growth. If your stock rises 15%, for example, but the annuity imposes a 10% cap, the maximum you can receive on the return is 10%.
- Can I lose money with a fixed or indexed annuity?
- You can’t lose money with a fixed annuity since it has a guaranteed interest rate on your investment. With an indexed annuity, your principal is protected from losses. If the market declines, however, you may not earn interest during that time.
- Which type of annuity is better for retirees?
- A fixed annuity might be best suited for a retiree who wants a steady source of income. On the other hand, an indexed annuity could be best for those willing to take on more risk in exchange for the potential to earn higher returns. The right choice boils down to your investment style and your priorities at retirement.
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- Investor.gov. "Annuities."
- IRS. 2023. "Publication 575 (2023), Pension and Annuity Income."
- FINRA.org. "The Complicated Risks and Rewards of Indexed Annuities."
