Fixed vs. Fixed Indexed Annuities: How They Work

How a fixed annuity earns interest

According to the National Association of Insurance Commissioners (NAIC) Buyer's Guide for Deferred Annuities, "Money in a fixed deferred annuity earns interest at a rate the insurer sets. The rate is fixed (won't change) for some period, usually a year." After that period, the insurer sets a new rate, which could be higher or lower. Fixed annuities generally have a guaranteed minimum interest rate stated in the contract, the lowest the annuity can ever earn while you own it.

How a fixed indexed annuity earns interest

A fixed indexed annuity is still a type of fixed annuity, but the interest is tied to an index rather than a rate the insurer simply announces. The NAIC guide explains: "The insurance company uses a formula to determine how a change in the index affects the amount of interest to add to your annuity at the end of each index term." Even so, "you aren't investing directly in the market or the index" when you buy one. If the index falls during the term, the guide notes your annuity earns zero interest for that term rather than losing value, as long as you do not withdraw money early.

Caps, participation rates, and surrender charges

The formula that determines your credited interest usually limits how much of an index gain you actually receive. The NAIC guide defines the three common mechanisms: a participation rate "determines how much of the increase in the index is used to calculate index-linked interest," a cap rate is "typically, the maximum rate of interest the annuity will earn during the index term," and a spread rate is "a set percentage the insurer subtracts from any change in the index," also called a margin or asset fee.

Insurers can use one of these or a combination, and the specific rates differ by contract and can change at renewal, so ask what applies to your specific policy and how it can change over time.

Both fixed and fixed indexed annuities typically charge a fee if you withdraw a large amount during an early "surrender charge period." Per the NAIC guide, this charge is "a percentage of the amount you take out of the annuity," and that percentage "usually goes down each year until the surrender charge period ends." Many contracts let you withdraw a smaller amount each year, usually up to 10%, without triggering the charge. If you take out everything, you have surrendered the annuity and given up any future income payments from it.

• Fixed annuity: interest rate set by the insurer, guaranteed minimum stated in the contract.
• Fixed indexed annuity: interest tied to a market index, subject to a cap, participation rate, or spread, with a guaranteed floor of zero for a down index period.
• Both can carry surrender charges for early withdrawals above any penalty-free amount.

Free-look period

After you receive the contract, most states give you a window to change your mind and return it. The NAIC guide describes it this way: "In many states, a law gives you a set number of days (usually 10 to 30 days) to change your mind about buying an annuity after you receive it. This often is called a free look or right to return period." The exact number of days, and whether you get back your full payment or the current account value, depends on your state, so check your own contract and disclosure documents rather than assuming a standard number.

Annuities are not FDIC insured

Annuities are insurance products, not bank deposits. The FDIC lists annuities among the financial products it does not insure, alongside stocks, bonds, and mutual funds.