What Is an Index Annuity?

An index annuity is a type of annuity contract that pays an interest rate based on the performance of a specified market index, such as the S&P 500. It differs from fixed annuities, which pay a fixed rate of interest, and variable annuities, which base their interest rate on a portfolio of securities chosen by the annuity owner. Index annuities are sometimes referred to as equity-index or fixed-index annuities.

Key Takeaways

An index annuity pays a rate of interest based on a particular market index, such as the S&P 500.

Index annuities give buyers an opportunity to benefit when the financial markets perform well, unlike fixed annuities, which pay a set interest rate regardless.

However, certain provisions in these contracts can limit the potential upside to only a portion of the market's rise.

How Index Annuities Work

How Index Annuities Work

Index annuities offer their owners, or annuitants, the opportunity to earn higher yields than fixed annuities when the financial markets perform well. Typically, they also provide some protection against market declines.

 The rate on an index annuity is calculated based on the year-over-year gain in the index or its average monthly gain over a 12-month period.

While index annuities are linked to the performance of a specific index, the annuitant won't necessarily reap the full benefit of any rise in that index. One reason is that index annuities often set limits on the potential gain at a certain percentage, commonly referred to as the "participation rate." The participation rate can be as high as 100%, meaning the account is credited with all of the gain, or as low as 25%. Most index annuities offer a participation rate between 80% and 90%—at least in the early years of the contract.

If the stock index gained 15%, for example, an 80% participation rate translates to a credited yield of 12%. Many index annuities offer a high participation rate for the first year or two, after which the rate adjusts downward.

Content was sited from Investopedia's article on Index Annuity

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