Investing in Indexed Annuities vs Index Funds

Key Takeaways

• A fixed index annuity, or an indexed annuity, is a type of annuity contract that earns interest based on the performance of a market index, like the S&P 500. They guarantee a certain return irrespective of market performance.
• In order to guarantee protection from losses, indexed annuities come with contractual limitations like participation rates, rate caps, and spreads that limit their potential upsides.
• When choosing whether to invest in indexed annuities or index funds, investors should understand that these investments differ across cost, liquidity, and taxation. They should pick the option that best aligns with their unique risk tolerance and investment horizon.

Indexed annuities promise the best of both worlds: protection against market declines and participation in growth when the market gains. But how do indexed annuities actually stack up against investing directly in index funds, which offer volatile but historically rewarding returns?

In this article, we’ll first explain what indexed annuities are and how they work. We’ll then explore how they compare to index funds. Finally, we’ll help you evaluate which option is best for you.

Definition of Indexed Annuities

A fixed index annuity, or an indexed annuity, is a type of annuity contract that earns interest based on the performance of a market index, like the S&P 500.

What makes indexed annuities enticing is their ability to offer participation in market gains while ensuring protection from market losses. Indexed annuity contracts often include a guaranteed minimum interest rate, which guarantees a certain return no matter how the market performs. The rate typically ranges from 1-3%. 

This means they don’t suffer any losses when the index declines – they only realize gains when it increases. 

Limitations of Indexed Annuities

It’s important to understand that in order to guarantee protection from losses, indexed annuities come with limitations that temper their potential upsides.

Participation Rates

Indexed annuities often have participation rates which limit gains to only a portion of the index’s rise. For example, if the market index increases by 7% and the participation rate is 90%, the annuity will be credited with a 6.3% return (90% of 7%). 

Credit to the annuity = Index Return * Participation Rate 

Participation rates range from 25% to 100% but most hover between 80% and 90%. They’re often set at this rate for the first few years of the contract before being adjusted downward.

Rate Caps

In addition, yield, or rate, caps may impose limits on how much of the index gains are credited, regardless of the total market growth. For instance, an indexed annuity with a 5% cap will receive a credit of 5% regardless of whether the index returns 5%, 7%, or 10%. Rate caps typically range from 2% to 15%.

Spreads

A spread, or margin, is the percentage that is subtracted from index gains before being credited. For example, if the index gains 7% and there’s a 2% spread, the annuity will be credited 5%. Spreads typically average 2%. 

Credit to the annuity = Index Return – Spread 

So while indexed annuities offer a unique opportunity to participate in stock market performance, they also come with limitations that require careful consideration.

It’s important to carefully review each indexed annuity’s contract and whether it includes a participation rate, rate cap, or a spread before deciding if it is the correct financial instrument for you.

Indexed Annuities vs Index Funds

When evaluating whether to invest in indexed annuities or index funds, it’s important to understand that they differ across more lines than just downside protection and market participation. They vary widely across cost, liquidity, and taxation.

Fees

Indexed annuities tend to have higher fees due to their complex structure and guarantees.

They often come with annual fees, like mortality fees which guarantee payments to a beneficiary in the event that the annuitant dies prematurely. Annuitants also have the option to add riders, which are optional benefits you can tack onto a contract for an additional fee. They’re typically charged as a percentage, let’s say 1%, of the annuity’s value on an annual basis.

On the other hand, index funds typically exact lower fees, especially when passively managed. Expense ratios for index funds like broad market ETFs are often less than 0.1%, making them very cost-effective and increasing the compounding effect of long-term investment.

Liquidity

Indexed annuities usually come with hefty withdrawal penalties that limit their liquidity.

In most cases, annuitants must pay surrender charges to the insurance company if they withdraw funds during the contract’s term, which typically ranges from four to eight years but can be up to ten years. The IRS may also issue a 10% withdrawal penalty if you withdraw before age 59 ½, which is the same fee on early distributions from retirement accounts like a 401(k) or IRA. 

Conversely, index funds, especially ETFs, offer substantial liquidity. They can be traded quickly and efficiently during market hours, allowing investors to capitalize on or shield against market movements without enduring significant fees or restrictions. This makes them a more flexible option for active investors.

Taxation

Annuity earnings are tax-deferred, allowing gains to accumulate without immediate taxation. However, when withdrawals begin, earnings are taxed at ordinary income rates, which may be less favorable compared to capital gains tax rates applicable to ETFs. Additionally, heirs of annuity holders might face ordinary income tax on gains, unlike the stepped-up basis benefit for inherited stocks and ETFs.

Index funds benefit from long-term capital gains tax rates, which can be advantageous if the assets are held for longer than one year. Index fund capital gains are taxed as short-term capital gains, which is generally at the same rate as ordinary income, if the assets are sold within a year. If they’re sold after one year, they’re taxed as long-term capital gains at 0%, 15%, or 20% based on your income.

It’s important to consider when you are planning to liquidate the asset, and what tax bracket will be applied, to evaluate the associated tax liability of these investments.

Which is Right for You?

When evaluating whether to invest in indexed annuities or index funds, it’s essential to assess your objectives and align your choice with your risk tolerance and investment timeline.

Risk Tolerance

Indexed annuities promise an element of principal protection and tax-deferred growth, which is suitable for more conservative and risk-averse investors. They often appeal to retirees who desire a stable stream of income but don’t want to completely forgo market-linked earnings.

Meanwhile, index fund ETFs are typically higher risk as they don’t offer principal protection but do have uncapped upside potential. They provide direct exposure to market indices, which provides the potential for higher returns as well as the risk of declines from market fluctuations.

Investment Horizon

Indexed annuities’ illiquidity makes them ideal for investors with a longer investment horizon, typically over five to ten years, due to withdrawal penalties during the accumulation period.

Conversely, index funds’ substantial liquidity might appeal to those seeking more flexible entry and exit points. However, as discussed above, index funds’ capital gains are taxed at a lower rate as long-term capital gains if they’re held for more than one year.

Feature	Indexed Annuities	Index Fund ETFs
Growth	Limitations on growth like participation rates and rate caps	No limitations on growth from market performance
Losses	Principal is protected	No downside protection
Liquidity	Surrender charges and potential for IRS early withdrawal penalties	Easily bought and sold
Cost	Higher due to annual fees and optional riders	Lower especially when passively managed
Taxation	Tax-deferred allowing for accumulation but earnings are taxed as ordinary income once withdrawals begin	Taxed as short-term capital gains if sold within one year or as long-term capital gains if sold after one year

Summary

Indexed annuities promise a unique blend of protection and growth. However, it’s important to understand their limitations and how they stack up against investing in an index fund. When deciding whether to invest in indexed annuities or index funds, choose the investment that best aligns with your risk tolerance and investment horizon. If you’re leaning toward investing in indexed annuities, consider consulting a financial advisor to help review the contract and assess whether it meets your goals.