How Do Index Annuities Work?

For some investors, annuities are a way to preserve wealth in the long run without exposing themselves to risks of traditional investing. Whereas traditional fixed annuities provide you with a defined benefit each month, equity-indexed annuities allow investors the opportunity to protect their investments while adding a chance for additional returns if the market performs well.

Basics

When you purchase an index annuity, you enter into a contract with the insurance company providing it. At its heart, for its purchase price, you receive a monthly benefit that’s partially tied to an index, such as the Standard & Poor's 500 index or the Dow Jones industrial average. When the economy’s good and these indexes rise, the size of your benefit increases as well. Because this is an annuity and not a traditional investment, you're protected if the market tanks. Your contract guarantees you a minimum monthly benefit, which is usually locked in as the benefit you receive at the beginning.

Fine Print

The security that protects your investment against downturns in the market comes at a price. Although your benefit might increase along with the index it's linked to, you probably won’t see growth that matches the index’s return. Although details vary between annuities, you might receive only a portion of the increase in the index’s value, or there could be an annual cap on your earnings. In addition, if the annuity receives any dividends in its investments, you won’t see any of those extra earnings. Also, administrative fees can eat away at your earnings.

Example

You purchase an equity-indexed annuity with a guaranteed return of 2 percent. It caps annual growth at 8 percent, and it charges a 1.5 percent fee on all earnings. The first year the market booms, gaining 10 percent. Your earnings are capped at 8 percent, and the insurance company takes a 1.5 percent cut of your earnings as overhead. You receive a 6.5 percent return on your investment that year. The next year the market tanks and drops 15 percent, ending lower than when you made your initial investment. This year, you’ll receive your guaranteed 2 percent return.

Surrender Charges

An annuity isn’t like a traditional investment that allows you to pull out your money easily if your financial situation changes. An annuity is a contract with a long-term commitment, and buying into an index annuity effectively ties up your money in the investment. If your situation changes -- for instance, if you need cash for a medical emergency -- you’re going to forgo a hefty chunk of your initial investment as a surrender charge. Surrender charges can run as high as 20 percent of your remaining investment, according to CNN Money.

About the Author

Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.