What is an Index Annuity?

An index annuity is an annuity that pays a rate of return corresponding to a particular index, such as the S&P 500 Index.

How Does an Index Annuity Work?

An annuity is a contract whereby an investor makes a lump-sum payment to an insurance company, bank or other financial institution that in return agrees to give the investor either a higher lump-sum payment in the future or a series of guaranteed payments.

Let's assume you'd like to invest in a vehicle that will provide guaranteed monthly payments of $1,000 to you every month for as long as you live after you retire in five years. An annuity may require you to deposit, say, $175,000 now to obtain this guaranteed future stream of income. The insurance company in turn invests this $175,000 in order to generate your monthly payments. If the insurance company invests this money wisely, it can earn more on the money than it has to pay out to the owner of the annuity and thus turn a profit.

With an index annuity, the insurance company invests the money and then agrees to pay the owner a set percentage of the increase in a particular index, up to a maximum of a certain percent. For example, a Company XYZ index annuity might pay the investor 85% of the annual increase in the S&P 500, guaranteeing a minimum of 3% per year and a maximum of 9%. So if the index is up 10% in a year, the annuity will pay 85% of this, or 8.5%. But if the index is up 25%, the annuity will pay only the maximum 9% that year.

Index annuities often guarantee a minimum return as well. If the index actually is down 15% in a year, the investor will get his minimum 3% return. Some index annuities will even guarantee the investor a minimum return over the entire life of the annuity. This downside protection offered by most index annuities is clearly more attractive during bear markets. But they are also attractive during bull markets because investors can still participate in a portion of the run-up.

An annuity investor typically begins receiving payments after the surrender period expires and the investor is at least 59 1/2 years old. The surrender period is the time (usually about seven years) during which the investor must keep all or a minimum portion of the money in the account or face surrender fees equal to a percentage (usually about 10%) of the withdrawal amount. The surrender period on index annuities is often seven to 10 years, which is longer than other annuities. Unlike IRAs, there are no restrictions on how much an investor can put into an annuity.

Why Does an Index Annuity Matter?

Index annuities can be very attractive investments for people who want guaranteed income and want to participate in the markets but with limited downside risk. They also have tax advantages: like 401(k)s and IRAs, for example, the interest, dividends and capital gains earned on an index annuity's underlying investments are tax-deferred until withdrawal (this means there is usually no additional benefit from holding annuities in IRAs or other tax-advantaged accounts). This provides two rewards: all of the annuity's principal and interest keeps working for the investor, and investors who use annuities for income in retirement are often in a lower tax bracket during retirement than when working, which provides tax savings.

However, wise investors must consider some important drawbacks to index annuities and annuities in general. For one, annuity investors pay taxes on gains at their ordinary income tax rate (rather than the lower long-term capital gains rate) when they make withdrawals. Further, when a beneficiary inherits an annuity, he or she is taxed on the annuity's gains at the ordinary tax rate instead of getting a step-up in basis as would be the case if he or she had inherited mutual fund shares.

Unlike bank deposits, the FDIC or other agencies do not insure annuities, and if the issuer goes bankrupt, an annuity can lose some or all of its value. Therefore, it is important to consider the creditworthiness of an issuer when shopping for an annuity. Best's Rating Service, Moody's and Standard & Poor's all provide this service.

Fees are also a major source of controversy for annuities. There are often front-end loads, state taxes, annual fees based on a percentage of the account value, early withdrawal penalties, etc., and they may offset much or all of an annuity's tax advantages. Pressuring sales tactics and less-than-transparent disclosure also have tarnished the image of annuities, so wise investors should be sure to read these disclosure materials and ask his or her financial consultant plenty of questions.

Ultimately, the appropriateness of an index annuity is dependent on the investor's financial goals, tax situation and the types of annuities available. Inflation and interest rate expectations may affect the type of annuity an investor chooses, as will the investor's wishes for his or her dependents and heirs.