Understanding Annuities: How Do Indexed Annuities Work?

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Indexed Annuity Contract Features

Before purchasing an indexed annuity, it is important to understand various contract features and their potential impact on annuity performance.

The Index
Indexed annuities credit interest based on the movement of the stock market index to which the annuity is linked. A market index tracks the performance of a group of stocks representing a specific market segment or the entire stock market. The S&P 500 is the index most commonly used for this purpose. Another index, however, may be used, such as the Dow Jones Industrial Average, NASDAQ 100 or Russell 2000. It is important to understand that when you buy an indexed annuity, you are purchasing an insurance contract and not shares of any stock or index.
Indexing Method
An indexed annuity earns a minimum rate of interest and then offers the potential for excess interest earnings based on the performance of the index to which the annuity is linked. The indexing method is the approach used to measure the amount of change in the index and, as a result, has a direct impact on the potential growth of an indexed annuity. Additional information is available on page 8.
Participation Rate
The participation rate determines how much of the increase in the index will be credited to the indexed annuity. The participation rate is usually less than 100%. For example, if the S&P 500 increases by 10% and the participation rate is 80%, the indexed annuity would be credited with 8%. The insurance company may have the right to change the participation rate from year to year or when the annuity is renewed for a new term.
Margin/Spread/Administrative Fee
Some indexed annuities subtract a specific percentage from the calculated change in the index before crediting interest to the contract. This "margin," "spread" or "administrative fee," which may be charged instead of, or in addition to, a participation rate, is subtracted only if the change in the index produces a positive interest rate.
Index Term
This is the period over which index-linked interest is calculated and/or the length of time during which withdrawals or surrenders are subject to a charge.
Cap Rate
Some indexed annuities put a cap or maximum on the indexlinked interest that will be credited to the annuity. For example, if the market index increases 20% and the annuity has a 15% cap rate, only 15% will be credited to the annuity. Not all annuities have a cap rate.
This is the minimum guaranteed interest that will be credited to the annuity. This guarantee is based on the claims-paying ability of the issuing insurance company.
Some indexed annuities use an average of the changes in the index's value rather than the actual value of the index on a specified date.
Interest Compounding
Some indexed annuities pay simple interest during the index term, while others pay compound interest, meaning that index-linked interest that has already been credited to the contract during the term also earns interest in the future.
Exclusion of Dividends
In measuring index gains, most indexed annuities count only equity index gains from market price changes and exclude any gains from dividends.
In some indexed annuities, none or only part of the index-linked interest is credited to the contract if the annuity is surrendered before the end of the term. The combination of these policy features found in any particular indexed annuity will make a difference in the amount of money your annuity investment will earn and in the amount of money you will receive if you surrender the annuity early. As a result, before you purchase an indexed annuity, it is important that you fully understand the various features in the contract you are considering.

Indexing Methods ^Top

Each indexing method generally contains preset combinations of features, which impact the potential growth of your annuity investment.

Annual Reset (or Rachet)

Index-linked interest is determined each year by comparing the index value at the end of the contract year with the index value at the start of the contract year. Interest is added to your annuity each year during the term. Any declines are ignored.

Advantages Disadvantages

High Water Mark

Looks at the index value at various points during the term, usually annual anniversaries. Interest is then based on the difference between the highest index value and the index value at the start of the term. Interest is credited at the end of the term. Advantages Disadvantages


Compares the change in the index at two distinct times, such as the beginning and ending dates of the contract term.

Advantages Disadvantages

Indexed Annuity Income Phase ^Top

When you are ready to begin receiving income from an indexed annuity, you can select from a variety of options, including:

Lump Sum Distribution

You can surrender your indexed annuity and receive the entire value in a lump sum payment. This option requires that income tax be paid on the indexed annuity earnings in the year you receive them. In addition, a lump sum distribution does not solve the problem of outliving your retirement income.

Systematic Withdrawals

You can set up a systematic withdrawal plan, through which you receive a specified amount of money at regular intervals, such as $1,000 per month, until all assets have been withdrawn. With this option, you have the flexibility to change the payment schedule in the future. Since, for income tax purposes, earnings are considered withdrawn before principal, the likelihood is that the earlier withdrawals will be fully taxed at ordinary income tax rates. In addition, with this option there is no guarantee that you will not outlive your retirement income.

NOTE: A lump sum distribution or systematic withdrawals made prior to age 59-1/2 may be subject to a 10% federal tax penalty on the taxable amount of earnings withdrawn, unless one of the exceptions is met.


You convert the value of your indexed annuity into a lifetime income or into a stream of payments for a fixed period of time. As reviewed on page 10, there are a variety of annuity income options from which to select.

Other Options

Talk to your licensed financial adviser about other options that may be available in the indexed annuity contract you are considering.

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