500 / What is a fixed index annuity ("index annuity")?
A fixed index annuity is a fixed deferred annuity in which interest crediting is done retroactively, at the end of the crediting period (which may be one year or more) and where the crediting rate is linked to the changes in the value of an external index such as the S&P500®. Most contracts offer multiple indices and the contract owner may select one or more of them.
There are no immediate index annuities because interest crediting is done retroactively and the insurer cannot link interest assumed in the annuity benefit guaranteed at the time of issue to future changes in the index or indices.
While some index annuities have been registered as securities by the issuing insurer, most contracts are not, and are not considered securities by the SEC. That said, some state securities departments assert jurisdiction over their sales. The sale of fixed index annuities was set to become subject to the "best interest contract" (BIC) prohibited transaction exception (PTE) of the fiduciary duty rule published by the Department of Labor (DOL) in 2016, whereas sales of declared rate fixed deferred annuities were to be allowed in accordance with the less-onerous PTE 84-24. However, the Fifth Circuit vacated the DOL fiduciary rule in March 2018, and the DOL officially removed the best interest contract exemption in 2020 (see Q 3982 for a discussion of the PTE 2020-02, which was designed to replace the 2016 rule). In 2024, the DOL finalized a controversial new replacement that would likely have impacted annuity sales, yet the DOL has announced that it will not enforce the 2024 standard under the second Trump administration. The long-standing five-factor test established in 1975 still applies. See Q 3986 for details.
Like all fixed deferred annuities, an index annuity guarantees a minimum interest rate provided that the contract owner holds the contract for the entire surrender charge period, though the guaranteed rate for index annuities is typically lower than that of declared rate contracts. Both types may include a market value adjustment (MVA) (see Q 530) and typically impose a schedule of surrender charges (which may vary widely in size and duration).
There are many different methods of interest crediting. All of them begin with the calculation of the percentage change in the value of the indices chosen over the crediting period, usually, but not always, excluding dividends on the stocks in those indices. That percentage change is then modified by the application of one or more crediting factors, or "moving parts", in the contract, and the result is the interest percentage to be credited to the annuity contract. The most typical "moving parts" are as follows:
Participation Rate: The participation rate is the percentage of the increase in the index that will be used to calculate index-linked interest. For example, if the index value rises by 9 percent over the crediting period (which may be one year or more) and the participation rate is 70 percent, the index-linked interest rate to be credited at the end of the period is 6.3 percent (9% × 70% = 6.3%) if there are no other modifying factors. The participation rate may be guaranteed for the life of the contract or for only one crediting period (and may be changed for the next period). A minimum participation rate is usually guaranteed.
Spread/Margin/Administrative Fee: Some indexed annuities use a spread, margin or administrative fee in addition to, or instead of, a participation rate. This percentage will be subtracted from any gain in the index linked to the annuity. For example, if the index gained 10 percent and the spread/margin/fee is 3.5 percent, then the gain in the annuity would be only 6.5 percent.
Interest Rate Caps: Some indexed annuities may put a cap or upper limit on total return. This cap rate is generally stated as a percentage. This is the maximum rate of interest the annuity will earn. For example, if the index linked to the annuity gained 10 percent and the cap rate was 8 percent, then the gain in the annuity would be 8 percent. (Note that indexed annuities that have caps may have a higher a participation rate.) Some contracts use an index rate cap, which is the maximum amount of index change that will be recognized before application of other modifications, rather than a cap on the amount of interest to be credited ("interest rate cap"). As with the participation rate, the interest rate cap may be guaranteed for the life of the contract or for only one crediting period. Typically, a minimum cap value is guaranteed.
Contract Designs
There are several index annuity designs. The simplest is the "Annual Point to Point", which measures the percentage change in the index each year and credits that change (after modifications) as interest at the end of each period.
"Term End Point" is a design that measures the index change at the end of a multi-year term and credits that change, after modifications, as interest at the end of the term.
"Averaging" is used in some designs, so that the average percentage change in the index, rather than the point-to-point change, is used. In "monthly averaging", most contracts place a cap on the positive monthly changes but not on any negative changes (monthly losses).
There are many index annuity designs and some are extremely complicated. For example, a newer design is to use an index that controls for volatility of changes in the raw index.
No Market Losses
Nearly all index annuities provide that any negative changes in the index over the crediting period will be credited as a 0 percent gain. Thus, the buyer of an index annuity is not subject to any market losses. However, it is not true to say that one cannot lose money in an index annuity, as surrender charges and/or market value adjustments may result in a surrender value lower than the original purchase amount, but only if the contract is surrendered during the surrender charge period.