How Does a Fixed Index Annuity Work?

Okay, so you're here for a reason. I'm assuming you've been pitched an Indexed Annuity, and your question is, how does a Fixed Indexed Annuity work? You need to know the details. Something in the presentation or something you heard didn't click right, and you want to know the truth about them. I'm glad you're here because we're going to talk about that. We're going to go through all the details of indexed annuities, which could go down as one of the most overhyped strategies of all time. That's unfortunate because I think it is a good product if people understand the good, the bad, and the limitations. And at the end of the blog, I’d like you to stick around because I think you'll walk away saying, “Huh, I get it.” You'll understand whether it fits what you want to do or doesn't.

I've written two books you'll want to get after this, and I'll tell you how to get them for free with no obligation. No one will call, show up at your doorstep, or pester you. We treat you like a professional. One book is the Indexed Annuity Owner’s Manual, and the other is the Income Rider Owner’s Manual. The reason for the two books is that the Indexed Annuity is typically sold with an attached Income Rider. I’ll also explain why and whether that makes sense for you to consider.

What is an Indexed Annuity?

Let’s get into it. What’s an Indexed Annuity? What does it solve for? How does it work? What are the benefits, limitations, and all that? In essence, a Fixed Indexed Annuity is a Fixed Annuity. It’s a principal-protected strategy. There are two similar examples in the annuity world: the fixed annuity (also called a Multi-Year Guarantee Annuity) and the Indexed Annuity (the Fixed Indexed Annuity). Both are life insurance products. They're not securities, so you need a life insurance license to sell them. That doesn’t mean they’re good or bad—that's just how they work. They’re contracts.

Indexed Annuities fit in your portfolio if you want principal protection and a return better than CD rates. They were developed in 1995 to compete with CD returns and offer enhanced returns. I know that’s how they’re sold in a lot of cases. They’re sold as market products, but they’re not. They’re not securities. So, how do they fit? They fit for principal protection and CD-type growth. Some years, you might get a 6 or 7% return, and some people hype even higher returns, but they can’t guarantee them.

In my world, you buy an annuity for what it will do, not what it might do. The will-do is the contractual guarantees, and the might-do is all the hypothetical, theoretical, backtested, projected, hopeful agent return scenarios. Never buy an annuity based on the might-do. Annuities are contracts. They’re a transfer-of-risk strategy. So, what does an Indexed Annuity do?

1. It protects your principal. That’s a good thing.
2. You can get returns that are typically, historically, a little better than CD returns.
3. You can attach an Income Rider or income benefit to the policy.

The Income Rider

Let’s take a deeper look at attaching an Income Rider to an Indexed Annuity. I’ve brought out the whiteboard—this is serious! Typically, I can explain the contractual guarantees without this, but I think it’s helpful to see how an Indexed Annuity works with an Income Rider. So, here’s your Fixed Indexed Annuity on the left.

Now, imagine I draw a line down the middle of a sheet of paper (or the board). On one side, you have the accumulation value. On the other side, you’ve attached an I_ncome Rider_. By the way, you don’t have to attach an Income Rider to an Indexed Annuity. If you just buy the Indexed Annuity without the rider, it’s a principal-protected, CD-type return product, and that’s fine. We use them with MYGAs (Multi-Year Guarantee Annuities) and fixed-type ladders, which work.

In this case, the person said, “I want to buy an Income Rider attached to it. I might need income in the future.” That’s fantastic. Let’s talk about the accumulation value. This is where all the hype is. People often say it’s market upside with no downside; market returns with principal protection. Sounds fantastic, right? Here’s the reality: It’s a call option on typically the S&P or some made-up option these days, but it's a call option from one contract anniversary to the next. There’s a limitation on what you can get, but once they lock in the gain, it’s guaranteed.

The will-do side is that, even if this doesn’t work during the surrender charge period, there’s a minimum guarantee. The minimum guarantee means you’re not going to lose any money.

What About the Income Rider?

On the Income Rider side, this is where the facts can be a little unclear. For example, I got a call the other day. A guy said, “Stan, I just bought a 7% annuity.” I had to correct him: “No, you didn’t. You bought a 7% income rider.” And that’s not a bad thing, but it’s not yield. Jimmy Carter isn’t in office anymore, and those yields aren't coming back. It’s not yield because you can’t peel off the interest. You can’t call the annuity company up and get a lump sum. If you believe that, try calling them!

You can’t transfer it either. If you say, “Stan, I want to transfer this to another annuity,” only the accumulation value side transfers. The income rider side doesn’t. But that doesn’t make it bad. The Income Rider is a benefit attached for future income.

If you decide to defer income for 10 years, it’ll grow by 7% each year for those 10 years. Once you turn on the income stream (based on your life expectancy, or joint life expectancies if it's a joint payout), the income stream starts, and the income rider disappears. That’s okay, as long as you understand that’s how the product works.

Fees and Other Considerations

Also, you need to know the fees for the Income Rider. They typically range around 1% annually. That fee comes out of the accumulation value side, which limits growth. The fee grows by 7% until you turn on the income stream. After you turn it on, it’s locked in and deducted from the accumulation value every year. Again, that doesn’t make it bad, but you need to know the truth about these products.

That’s how a Fixed Indexed Annuity works with an attached Income Rider. In the book, I go into detail about the accumulation value, caps, spreads, options, and choices. Right now, there are over 700 index options, representing over 50 indices and baskets. That’s a lot, and that’s why I don’t get too deep into the weeds with all of that. Just know that the product was introduced in 1995 to compete with CD returns.

Understanding the Product

Over time, those options will generally perform as expected. Some years will be better than others. If you buy an indexed annuity with the structure of an accumulation value and an income rider, the income rider value will almost always be higher than the accumulation value. This is important because you can’t transfer the income rider value or cash it in. It’s used to calculate your first income stream payment based on your life expectancy.

So, let’s say you put $100,000 in it. After 10 years, the accumulation value might be worth $150,000, but the Income Rider value could be $200,000. If you cash out after 10 years, you’ll get $150,000, and if you want to access the $200,000, it has to be in income payments, not a lump sum.

Conclusion

That’s a visual breakdown of what you're being pitched. It doesn’t mean it’s bad—it’s flexible. If, after 10 years, your lifestyle changes and you don’t need the Income Rider, you can get your money back or just let it accumulate.

Okay, I’ve thrown a lot at you about Indexed Annuities and how they work with Income Riders. To dive deeper, you’ll want to get the books by downloading them for free.

I want you as a client. I’m licensed in all 50 states, but I want you to understand the products first. The only urgency in buying an annuity is never. The urgency is for you to understand what the product does because you're buying a contract at the end of the day.

I'm glad you joined us—I hope you learned a lot, and I look forward to seeing you next time!