Paying for Care
Fixed Annuities vs Indexed Annuities: How Each One Grows and What the Caps Mean
A fixed annuity grows at a rate the insurer states in the contract. An indexed annuity grows by a formula tied to a market index, with a cap that limits the gain. Here is how each one works, in clear terms.
Key takeaways
- An annuity is an insurance contract sold by a life insurance company. It can build value over time and can later pay income, in some designs for life.
- A fixed annuity grows at a rate the insurer states. Fixed deferred contracts carry a minimum credited rate set in the contract, per the NAIC.
- An indexed annuity ties interest credits to an outside index, such as the S&P 500, and also carries a minimum rate set in the contract, per the NAIC.
- You do not own the stocks in the index. The index is a yardstick used in a formula.
- A cap is the top rate the insurer will credit in a set span, no matter how high the index climbs in that span.
- No rate, cap, or payout figure is stated in this guide. Those numbers live in each contract, and they change from contract to contract.
An agent shows you two annuity contracts. One states a set rate of growth. The other ties growth to a stock market index and speaks of strong past index years. The two contracts grow in very different ways, and the gap sits in a few contract terms that are easy to miss. This guide sets out how each one grows, what a cap does, and what to ask before you sign. Our Paying for Care section holds more guides on funding care and final costs, and our guide to annuities explained covers how income annuities pay.
How a fixed annuity grows
A fixed annuity grows in the plainest way of the two. The insurer states a rate. Your contract value earns interest at that rate for a set span. At the end of the span, the insurer sets a new rate for the next span, and the contract sets a floor the rate cannot fall below.
That floor is the part to find in writing. The NAIC states that fixed deferred annuity contracts guarantee a minimum credited interest rate. The rate for the first span can look good while the floor sits much lower. Ask for both numbers, in the contract's own pages, before you judge the deal.
Growth is steady and known in advance for each span. There is no link to the stock market. If the market has a strong year, your value still grows at the stated rate. If the market falls, your value still grows at the stated rate, as long as the insurer can pay. That steadiness is the whole trade: less gain in strong years, no market loss in weak ones.
How an indexed annuity grows
An indexed annuity ties its interest credits to an outside index of investments, such as bonds or the S&P 500. The NAIC notes that these contracts hold both fixed and variable traits: the credit is linked to the index, and the contract still carries a minimum guaranteed rate.
You do not buy the index, and no shares are held in your name. At the start of a credit span, the insurer notes the index level. At the end of the span, it notes the level again. The change feeds a formula in the contract. If the index fell, the credit for that span can be zero, or the small minimum the contract states, in place of a loss. If the index rose, the formula decides how much of that rise is credited, and the next section covers the limits that apply.
Credits are most often locked in at the end of each span. A gain that is credited stays in the value and cannot be lost to a later index fall, under the terms most contracts use. Read your own contract for its rule on this point, since designs vary.
What the caps mean
Three terms do most of the work in the indexed formula. Each one can cut the share of an index gain that reaches your account.
A contract can use one of these terms or stack more than one. A high cap means little if the participation rate is low. A strong participation rate means little if a low cap sits on top of it. The only safe way to judge the formula is to work a sample year by hand, with the agent, using the contract's own terms: a strong index year, a flat year, and a down year.
These terms are not fixed for life in most contracts. The insurer can reset the cap, the rate, or the spread at the start of a new span, down to the minimum levels the contract allows. Those minimum levels are the numbers that matter most over a long hold, and they sit in the contract, not in the sales talk.
- The cap is a ceiling. If the index gain for the span beats the cap, you are credited the cap and no more.
- The participation rate is the share of the index gain that counts. A rate below the full gain means only that share of the rise feeds the credit.
- The spread is a slice taken off the index gain before the credit is set. The gain that counts is the gain minus the spread.
Shared ground: charges, access, and taxes
Both shapes share some ground. Interest grows tax-deferred in both, and tax is due when money comes out. Both can carry surrender charges if you take out more than a set free amount in the early years. Both can add fees for added riders. Both rest on the strength of the insurer that sells them, since the promises are the insurer's own.
Access is a real test for both. Money in an annuity is not cash in a bank. If the sum you set aside is money you may need soon for care or for a house repair, the surrender terms can cost you. Our guide on term life vs whole life after 65 covers a like choice for life cover, where the job the money must do comes first.
Who pays for what
- The insurer credits interest under the contract terms: a stated rate for a fixed annuity, or the index formula with its limits for an indexed annuity.
- You pay the premiums or the one lump sum, and you bear surrender charges and rider fees the contract sets.
- Medicare does not pay annuity premiums. An annuity is not health cover.
- Medicaid has its own rules for how an annuity counts in its income and resource tests. Those rules are strict, and a contract bought at the wrong time can hurt a claim. Get advice before you buy if a Medicaid claim may lie ahead.
- Private pay funds the purchase in both shapes.
Sample situation
Ruth is 67 and holds a sum left from the sale of a house. An agent shows her two contracts. The fixed contract states a set rate for the first span and a lower floor rate after that. The indexed contract ties credits to a stock index, with a cap and a participation rate that the insurer can reset each span, down to stated minimum levels. Ruth asks the agent to work three sample spans by hand for the indexed contract: one strong index year, one flat year, and one down year. She sees the cap cut the strong year, the flat year credit near zero, and the down year credit zero with no loss. She asks for the reset minimums in writing, and she keeps the worked sample spans with the contract in her file. She picks the fixed contract, since she wants growth she can name in advance and plans to draw income in a few years. A buyer at ease with ups and downs, with a longer span to hold, might pick the other way on the same facts.
Questions to ask before you sign
- For a fixed contract: what rate is credited now, how long does it last, and what floor rate does the contract set after that span?
- For an indexed contract: what is the cap, the participation rate, and the spread today, and what are the lowest levels the contract lets the insurer set later?
- How does the contract note the index at the start and end of a span, and are past credits locked in?
- What are the surrender charges, year by year, and what sum can I take out free each year?
- What fees do riders add, and what do they pay?
- How strong is the insurer, and who checks its record in my state?