What Are Fixed Index Annuities, and How Do They Work?
The best part about fixed index annuities: protection from downside risk. And the closer you get to retirement, the more you want protection if the markets have another bad year.


Annuities are financial products that some advisers intensely criticize and others highly recommend. But the big question is, are they right for you?
Annuities may seem complex, largely due to the fact that there are a variety of product types and options. On one side of the spectrum lie high-fee, high-risk, high-potential-gain variable annuities, where your returns rise and fall with the stock market. On the other side of the spectrum are steady, CD-like fixed annuities that generate a fixed rate of return. But there is one type of annuity that can offer you the best aspects of each: the fixed index annuity.
What Are Fixed Index Annuities?
An FIA is a contract between you and an insurance company where you give the company a certain amount of money for an agreed-upon period of time, and your return is based on the performance of a chosen stock market index, or indexes. With FIAs, your principal is guaranteed, meaning that even if the chosen indexes are down at the end of the year, you cannot lose money.

Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Clients always ask me: What is the catch? How can you not lose money with an FIA when the market is down? One answer is that the insurance company is keeping your money for an extended period of time and can reinvest it. Another answer is that some FIAs can limit your total returns by using caps and participation rates.
A cap is simply a ceiling — that is, the highest percentage of interest you can gain, regardless of how the index performs. In other words, you forgo any gains that exceed the cap. With participation rates, the amount of interest you earn is a percentage, predetermined by the insurance company, of the total gains of the chosen index.
For example, let’s say the insurance company sets a 50% participation rate for a stock market index like the S&P 500. If the S&P 500 grows by 10% that year, you would receive 50% of that, or a 5% return on your investment.
Your FIA’s index rates are locked in for the duration of the chosen index, usually one or two years. Those rates can increase or decrease during the life of the contract, according to the company’s discretion, oftentimes reflecting the current interest rate environment—this is called the FIA’s “renewal rate.”
What Are the Benefits of Fixed Index Annuities?
The main advantage of fixed index annuities is their protection from downside risk. As many of our clients approach retirement and are no longer accumulating assets, they do not want 100% of their portfolio to be down if the market has a bad year.
Another big advantage is the annual lock, or reset feature, in which you lock in your gains when the annuity’s index has had a positive return. The growth is then locked in and resets to become the next year’s beginning balance.
Let’s say you have $100,000 in your FIA, and you get a 5% return. The next year, you would begin the year with $105,000. The value of your FIA can only go up or sideways — never backward. That is to say, even if the value of the index later decreases or flatlines, your annuity doesn’t lose any money, and you can never fall below your new $105,000 floor, in this example.
You can also use FIAs to generate an income stream in retirement. Almost all FIAs allow you to withdraw 10% of your account value without penalty after the first year. Additionally, some FIA products that include an income rider can generate an income stream for life, which we call a private pension.
Using FIAs for income can be attractive if you have an “income gap” in retirement, meaning your fixed income from Social Security and/or pensions is not sufficient to cover your monthly budget. Using an FIA in this manner can protect your investments in the stock market from having to be liquidated in a down market to generate a monthly cash flow.
Another advantage is that many fixed index annuities have no fees whatsoever assessed to the owner.
What Are Their Drawbacks?
While FIAs can be an excellent means of accumulating safe money, they are not silver bullet financial products. As is the case with all annuities, FIAs have a surrender schedule, which is a set period of time before an annuity’s maturity. If you sell or withdraw money from your annuity before that time window is complete, you have to pay a surrender penalty.
For example, if you have a 10-year surrender plan, you are giving your money to the insurance company for 10 years. With that in mind, FIAs offer less liquidity than some other financial products.
Moreover, because of the caps and participation rates associated with them, FIAs cannot compete with the upside earning potential of the stock market. If the market is doing well, money in the stock market will always outperform an FIA.
The Bottom Line
At the end of the day, there is no perfect investment vehicle. If there was, I would be out of business! However, if you want a reliable source of safe income in retirement, FIAs might be the ideal financial product for some piece of your portfolio.
Of course, don’t just take my word for it. Having a one-on-one conversation with a financial adviser is the best way to determine if FIAs are the right investment vehicle for you.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.

After losing both his mother to breast cancer and a significant amount of money that she left him, Tim became a Licensed Financial Professional to help people never feel as helpless as he did. As the Founder of Preservation Retirement Services, one of his joys in life is spending one-on-one time with clients to help them create safe retirement income strategies and preserve the money they worked so hard to earn.
-
Four Ways to Use Your Tax Return as a Financial Planning Tool
Rather than filing away your paperwork and forgetting about it, this CPA recommends using it as a source of insight to optimize your long-term financial strategy.
-
How Women Can Turn a Gray Divorce Into a Financial Win
Getting divorced later in life can be a big financial blow, especially for women. But, as this financial adviser points out, it can also serve as a positive turning point for growth and independence.
-
Private Markets: Six Things Investors Can Learn From BlackRock's CEO
BlackRock's chief executive, Larry Fink, recently argued the case for increased access to private markets. Here's how a financial professional sees Fink's views translating into action for accredited investors.
-
I Found Out What It Takes for a Family Business to Thrive
A handy book and my chat with the chairman of Community Coffee offer some guidance on making your family business a success.
-
The Future of Opportunity Zones: Outlook for 2025 and Beyond
There are three potential paths forward for this innovative tax incentive program that's set to expire in 2026.
-
How Private Equity in Your Portfolio Could Boost Returns
And reduce volatility. A few decades ago, private equity was considered a 'cottage industry.' Now, it is a multitrillion-dollar asset class.
-
Is Your Retirement in Danger of Crumbling?
Ignoring any of these five essential financial pillars could put your future at risk. Take a moment to make sure you haven't overlooked anything.
-
Three Financial Planning Strategies for When Markets Fall
Overall, stay the course, but these three strategies are ways investors can make market volatility work to their benefit.