If you are a homeowner nearing or in retirement, it's highly likely you've received an invitation to a dinner to hear about how to secure your retirement (or some variation). In almost all cases, this is a cover for a sales pitch on index annuities.

With that in mind, I want to offer my take on index annuities providing both the good points and not so good. These are confusing products but offer benefits investors should consider. In reality, it's not so much the product. It's the way agents sell the product. We will talk about that as well.

At the end of the post, you will have a better understanding of index annuities I will give you a list of ten questions to ask anyone trying to sell you one of these products. You'll be able to pick and choose the questions you like.

We have a lot to cover, so let's get started.

How to Know if Index Annuities Are Right for You

The basics

Let's start by defining what an annuity is and move into the various types. This will be a broad overview. Our focus will be on index annuities. Perhaps we'll do the same for the other annuity types.

An annuity is a financial product issued by an insurance company. The purpose is to provide a guaranteed stream of income, either right away (SPIA) or at some point in the future (deferred).

There are two basic types of annuities – single premium immediate annuities (SPIA) and deferred annuities.


With an SPIA, investors make an initial deposit which immediately begins paying out an income (monthly, quarterly, etc.) for a specific period. There are several payout options. Here are three.

  1. Life – distributes the income over the annuitant (investor or owner) lifetime.
  2. Life with a period certain – pays out over the annuitant's lifetime but with a minimum guaranteed period (say ten years). If the annuitant dies, the beneficiary will continue to receive payment for the guaranteed period
  3. Period certain – Pays out over a specific period only, not based on life expectancy.


[socialpug_tweet tweet=”With a deferred annuity, the investor can make a one-time deposit or, in some products, regular contributions over time.” display_tweet=””]

Rather than providing an income right away like an SPIA, deferred annuities payout cat a future date. Deferred annuities are the most common type. They come in multiple forms.

  1. Fixed – the insurance company offering a fixed annuity invests the money on your behalf. They typically have a minimum guaranteed interest rate below which your rate cannot fall. Fixed annuities are among the safest options. The financial health of the issuing company is critical in choosing an annuity, especially the fixed. The money in the annuity is only as good as the issuing company. Be sure you are working with a top-rated insurer.
  2. Variable – unlike a fixed annuity, in a variable contract the insurer offers a selection of mutual fund investments. Called subaccounts in an annuity, you choose from among the subaccounts to build your portfolio. Unlike fixed annuities, variable subaccounts are a separate asset from the insurance company.

Both types of deferred annuities have payout options similar to the SPIA when you decide to take income. The process of taking the income as described is called annuitization. When you take your income by annuitizing, you enjoy some tax advantages. The IRS considers part of each payment to be a return of principal (your original investment) and the other part income (earnings). You pay tax on the earnings portion at ordinary income tax rates.

Please keep in mind this section is a basic review of annuities. It is by no means enough to decide whether an annuity is right for you. The descriptions above are to provide a foundation for discussing index annuities. 

For further reading –What is an Annuity?

Index annuities

With that background, let's take a deeper dive into the topic at hand.

Index annuities are a type of deferred annuity. Called a fixed index annuity (FIA), they have elements of both a fixed and variable annuity (though limited). They have a guaranteed minimum return and the potential of higher performance. You may hear these described as equity-indexed annuities. It's the same product. The term equity left the impression that this was an investment in the equity markets. For that reason, that term is rarely used anymore. Keep reading, and you'll see why.

Elements of index annuities

A fixed indexed annuity is a deferred annuity with a guaranteed floor and an upside return tied to an index (S&P 500, Russell 3000, Dow Jones, etc.). One benefit is the opportunity to get a higher return than a fixed account with a guaranteed minimum return if the index loses money.

The investments

In fixed index annuities, the insurance company invests the bulk of your premiums (deposits) into fixed income investments like government and corporate bonds, mortgage-backed securities and other fixed-income instruments. They use the interest earned from the fixed income investments to buy call options on the index tied to the market. If the market goes up, they exercise their option and pocket the profits. That's where you get your return.

The drawback is there is a limit to the upside. In times when the market goes up substantially,  you will get less than that return. Instead, you'll get a percentage of that return. There are several methods to calculate the performance of the index.

Annual point to point

In the annual point to point method, the crediting period is typically from the inception date of the policy to that date one year later. It can also be every six months, or from the highest point during the year. The most common is on the anniversary date.

For example, if you put $100,000 into the annuity on February 1, 2019, your account value stays at $100,000 until February 1, 2020. If your crediting rate for the index to which the $100,000 is 5%, the account value on February 1, 2020, becomes $105,000. That's the process for each succeeding year in the point to point method.

Monthly point to point

The monthly point to point method calculates the monthly gains and losses of the index used. The annual interest is calculated by adding the monthly gains and subtracting the monthly losses to come up with the total return. The company uses that number to determine the return of the index for the year on the policy anniversary date.


In the averaging method, return gets calculated by averaging the returns at various points throughout the year (can be daily, monthly or some other interval). That average gets added to the beginning value to determine the ending value of the index. Dividing that number by the beginning value determines the return for the year.

The cap rate

[socialpug_tweet tweet=”The cap rate is the maximum percentage of return allowed by the insurance company. You may also hear this described as the participation rate. ” display_tweet=””]

For example, if the annual cap rate is 6% and the index return is 12%, your return will be 6%. In the monthly point to point, the percentage will be lower. A standard rate is 2.5%. So if a monthly return is 4%, the contract earns the 2.5% maximum (cap).

The cap rate may also show as a percentage. For example, a cap rate of 70% means that if the index return on the crediting date is 9%, you will receive 6.3% (9% x .70 = 6.3%).

If the return of the index is lower than the cap rate, that's the return credited to the account. If the cap rate is 7% and the index return is 5%, the account earns the 5%.

For a detailed analysis of the crediting methods read How It Works: Crediting Methods and Index Options.

The spread

The spread is yet another way insurance companies determine how much you make. Instead of a cap or a participation percentage, the spread is the amount subtracted from the index return to calculate your crediting rate. For example, if the spread is 4% and the index return is 9%, your crediting rate is 5% (9% – 4% (spread) = 5% net).

Other terms used to describe spreads are margins and administrative fees.

Minimum returns

[socialpug_tweet tweet=”Minimum returns vary greatly from contract to contract and company to company. The cap rates are the price you pay for having a product with a guaranteed minimum return. ” display_tweet=””]

If the market goes sideways (no growth) or drops, you get whatever minimum interest rate comes with the contract. That may be a minimum percentage, like 1% – 3% or a percentage of premium plus a margin. Some companies calculate it as a margin over the premiums you paid. The formula might be premiums plus 3%. For example, if you invest $100,000, your guaranteed minimum return would be $103,000


There are several things to consider if you want to get money out of your FIA. First, the IRS considers non-annuitized withdrawals to be earnings first. As such, you owe taxes on those earnings at ordinary income tax rates. After earnings are gone, the remaining withdrawals are a return of principal and not taxable. If you're under age 59 1/2, you pay an additional 10% early withdrawal penalty on earnings. This applies to annuities funded with after-tax dollars. Withdrawals from annuities in IRAs funded with pre-tax money (like IRAs, 401(k)s) are fully taxable.

Most FIAs allow you to take out up to 10% of the account value each year without penalty. For amounts over 10%, surrender charges apply. These charges and periods vary depending on the contract. They can be as short as five years and as long as ten, though that's rare nowadays. In general, the longer the surrender period, the higher the maximum charge.

For example, a five-year surrender period might have a 5% surrender charge in the first year dropping 1% each succeeding year. After the 5th year, it's zero. An eight-year would start at 8% and so on.

It's important to understand that any annuity, including FIAs, are illiquid investments. They are a long term investment designed to provide a guaranteed income at some future date. They are the last resort when you need cash.

Retirement Income Planning – What You Need to Know
How to Automate Your Way to Wealth
Why Investment Diversification Is Important for Success

Pros of FIAs

  • Can invest smaller amounts of money
  • No upfront fees or commissions
  • Tax-deferred growth
  • The potential for higher yearly returns than a fixed annuity
  • Provide a guaranteed lifetime income
  • Provide a guarantee of principle
  • They often perform better than a similar bond or other fixed-income investment

Cons of FIAs

  • There are caps on how much you can earn
  • The minimum guarantees are often lower than what you could get in a traditional fixed annuity
  • The guarantees are only as good as the company issuing them
  • Steep early withdrawal penalties
  • They are very confusing and hard to understand
  • Though the returns come from equity type investments (call options on an index) FIAs are not considered securities. As such, they are outside the stiffer regulatory requirements of other securities

Sales tactics

Like any investment product sold, there are good and not so good sales tactics. The main problem I have with FIAs is not the product itself, but the methods used to sell them.

As I mentioned in the beginning, one of the most popular ways to sell FIAs is via the dinner seminar. You receive an invitation in the mail to attend. You call a number to confirm. Typically, it's for you and a guest (presumably a spouse). Agents and brokers selling these products often target those who are in or nearing retirement. The invitations are chock full of hyperbole about not losing money, guaranteed income, and such. The fact is, those are all good things about the annuity.

It's what's left out that's the problem. The presentations are full of the benefits with minimal discussion of the risk or the alternatives available. Typically, charts of the return of the particular index that product uses will be prominently displayed somewhere. Attendees rarely read the fine print nor is it mentioned by the salesperson.

So, as you feast on your expensive steak dinner, you hear about the upside potential and the best parts of the product, many people sign up to make an appointment.

Ron Lieber, the noted New York Times financial writer, attended one of these dinners with his aunt. You can read about his experience in this article.

A better approach

I'm a believer that any investment product or strategy be part of an overall financial plan. Otherwise, it's just a product. In fairness, some advisors who put on these dinner seminars meet with prospective clients, do a plan, and, if appropriate, include an FIA as part of that plan. In my experience, that is rare.

If that were the goal, they wouldn't be making the claims they do in their invitation to get people to attend. Instead, they would promote their financial planning and have an FIA as part of the solutions offered if appropriate to the client's situation. FIAs are a viable product that solves a problem for people.

An FIA is a long term solution with tax-deferral and the potential for a higher return than bonds or other fixed-income investments. They offer a lifetime income and principal guarantee. If that helps you feel more secure in your retirement, this is a product to consider.

Ten questions to ask before buying an FIA

  1. What is the participation or cap rate?
  2. When does the company determine the cap rate (annual, monthly, or average point to point)
  3. If I invest $100,000, what will the one year value be if the market goes up, goes down, or stays the same?
  4. What has the crediting rate been for the last ten years?
  5. How long and how high are the surrender penalties?
  6. What is the minimum guaranteed rate?
  7. How is your insurance company rated?
  8. What annuitization options does the contract offer?
  9. Do I have to annuitize the contract at some point (like age 75, 80, etc.)?
  10. Why should I buy this over a fixed or variable annuity?

Final thoughts

Annuities have their place in retirement planning.

Unless you work for the federal, local, or state government, guaranteed income from pensions is a thing of the past. Less than 10% of public corporations offer them today. The only other source of guaranteed income comes from Social Security. In my view, the best reason to purchase an annuity is to provide a guaranteed income to supplement retirement.

Do your homework before talking to an agent or broker. Narrow the choices down to two or three companies and products. Know those products. Use the ten questions listed above to see how the broker or agent answers them. If you research them and know the answers before you ask the questions, you will flesh out the good from the bad salespeople.

When purchasing any investment product, always adhere to the Caveat Emptor principle. Let the buyer beware.

I hope this post offers good information to help you down that path. An educated consumer is a better consumer.

Now it's your turn. Have you looked at indexed annuities? Have been invited to a dinner seminar about retirement income? If so, what was your experience? Let me know in the comments below.