How do Indexed Annuities Work?

Annuities may seem like complicated financial tools, but they are quite basic in theory and can be an important part of a balanced financial portfolio. An annuity is simply a contract with an insurance company created to meet long-range retirement or savings goals. You pay in a certain amount, either by regular contributions or a by a lump sum. The insurance company then pays out the money, over a specific period of time, returning a rate of return based on a fixed rate or tied to an outside financial factor, such as a mutual fund or stock index. An indexed annuity provides a rate of return based on the performance of a stock index, thus the name.

The money contributed to an indexed annuity is usually tax-deferred; the money is taxed when it is withdrawn, usually at retirement when you are at a lower tax rate. The period when you make payments into the annuity is called the accumulation phase and the period when payments are made to you is called the payout phase.

There are three basic types of annuities. A fixed annuity pays out at a fixed rate, for a fixed period of time. These are the safest form of annuities and as such, pay the lowest rate of return. Variable annuities are based on a specific financial investment, usually stock mutual funds, chosen by the investor. The rate of return is based on the rate of return of the mutual fund. These are more volatile investments and can provide a higher rate of return if the mutual fund increases in value.

The third type of annuity, an indexed annuity, provides a good balance between the security of a fixed annuity and the variable return of a variable annuity. The rate of return of an indexed annuity is tied to the performance of a stock index. This may be the Dow Jones Industrial Average, Standard & Poors 500, or any number of other recognized indices. While the return usually has no upper limit, there is normally a limit to your loss, regardless of the performance of the index, the net amount you contribute is normally safe. So no matter how low the index may sink, your net contributions are protected.

Indexed annuities also have options or upgrades, such as additional death benefits as well as long-term care and other retirement-related products. The product was formerly known as an "equity indexed annuity," but the word equity was removed as these investments have no real vesting or equity in the stocks or index on which their returns are based. The returns are based on the index performance, using a pre-set formula, yet your money is not invested in the stocks or funds themselves.