Which Stock Market Indexes Can I Index My Annuity From?



Buying annuities is more popular than ever, as more Americans are looking to supplement their 401(k) or individual retirement account plans (IRA) with additional funds. Annuities are an excellent choice as a supporting portion of a comprehensive retirement plan, thanks to the fact that they don’t have strict annual contribution limits like traditional retirement accounts. Making annuities even better is their status as a tax-deferred retirement plan (just like a 401(k) or an IRA), meaning you won’t owe taxes on them until you start taking out withdrawals.


There are several different types of annuities and which one you choose depends on your priorities. However, one form of annuity stands head-and-shoulders above the rest as the most popular annuity in America to this day. More than half of all annuities purchased in 2019 were fixed indexed annuities, and this type of annuity remains extremely popular to this day.


Although, there is quite a bit of variance within the indexed annuity category. For instance, you have options regarding which corner of the stock market you want to index your annuity from. Let’s discuss the finer details of fixed indexed annuities and review where you can index them.



How Does a Fixed Indexed Annuity Compare to Other Annuities?


A fixed indexed annuity is just one of several different types of annuities. The fixed indexed annuity is sort of a “greatest hits” collection, in that it takes the best attributes of other types of annuities and combines them in one convenient fund. Why are fixed indexed annuities so popular? How do they relate to other annuities?


To begin, let’s take a small step back and discuss what a fixed indexed annuity is and how it differs from other types of annuities. A fixed indexed annuity grows along with the owner’s chosen market index. For instance, many people choose to index their annuities on the S&P 500. In this example, the annuity would grow at a rate that lines up with the S&P 500’s growth. In a way, the fixed indexed annuity combines elements of a fixed annuity and a variable annuity.




What Is a Fixed Annuity?


With a fixed annuity, your initial investment grows at a predetermined rate. Throughout the life of your annuity this interest rate will stay exactly the same. Whether you purchase a life annuity that provides guaranteed income until you die, or you choose a period-certain annuity that pays out for a set number of years, that interest rate won’t budge.




What Is a Variable Annuity?


A variable annuity is a close relative of the indexed annuity, but with just enough distinction to fulfill different investor needs. Instead of indexing the annuity on one market index, a variable annuity provides several options. The company that sells you a variable annuity will invest your funds in a variety of mutual funds, exchange funds, fixed investment accounts, etc. You can alter your portfolio as you see fit, swapping out investments for other ones. Compared to a fixed annuity, a variable annuity has a far higher upside. However, it also presents the risk of actually losing money in your annuity.




What Is a Fixed Indexed Annuity?


With a fixed indexed annuity, you get the best of all these worlds, which explains its popularity. The “fixed” portion of the name refers to the downside of a guaranteed baseline interest rate. Even if the market experiences a catastrophic collapse and loses money over the course of your annuity’s accumulation phase (the years before you withdraw your first payout), you will still earn the amount ensured by your fixed interest downside. However, if the market conditions are favorable throughout your accumulation phase, you will instead enjoy a higher interest rate driven by your chosen market.


There is still a tremendous amount of variance, even among fixed indexed annuities, based on where the annuity is indexed and how the rates are set, among other factors




Fixed Indexed Annuity Cap Rates vs. Participation Rates vs. Spread Rates


If the fixed indexed annuity sounds too good to be true, in a way, it is. The “fixed” portion of the annuity suppresses your earnings potential in a way that you wouldn’t find with a variable annuity. This is because there are three different kinds of rate limiters that suppress the upside of your fixed indexed annuity: cap rates, participation rates, and spread rates.




Cap Rates


Fixed indexed annuities may include what’s commonly known as a cap rate. This is the maximum amount of interest your annuity can gain during the accumulation phase. Cap rates can vary depending on who you buy your annuity from and other factors, such as the market you index it on. In general, cap rates usually run as high as 15% or as low as 5%, although it is still possible to have a higher or lower rate depending on the specifics of your fixed indexed annuity.




Participation Rates


If your fixed indexed annuity doesn’t have a cap rate, it’s likely that you will have a participation rate instead. Or, you could have both a cap rate and a participation rate. The participation rate is just a different way of capping your returns. Instead of setting a strict upper limit, the participation rate defines what portion of the index’s returns you will enjoy in your annuity.


You can find annuities with participation rates of 100%, which simply means that your fixed indexed annuity will receive full credit for any market growth. However, this is quite rare. Similarly, you might find a participation rate reaching down into the 30% range, but again, this is unusual. For the most part, participation rates land somewhere between 80% and 90%. Let’s illustrate this concept with an example. If you purchase a fixed indexed annuity with an 85% participation rate, and the indexed market earns 10% growth, your annuity will earn 8.5%.


It’s important to keep in mind that the company that issues your fixed indexed annuity might be able to change the participation rate. When you first purchase your annuity, the company that sold it to you will typically make a guarantee that they will not alter the participation rate for a set amount of time. This period usually lasts for at least one year, but often considerably longer than that. If you have a variable participation rate, check with your provider to see if there is a set range of potential rates. Oftentimes, a fixed indexed annuity will have minimum and maximum participation rates.




Spread Rates


Another way a fixed indexed annuity can limit your returns is through a spread rate. The spread rate is a flat percentage that is subtracted from your annuity’s earnings. Spread rates are probably the easiest form of annuity limiter to understand. For instance, if your annuity’s spread rate is 5%, and the index gains 14% over the course of your accumulation phase, the annuity would only experience 9% growth.



Where Can I Index My Fixed Indexed Annuity?


When it comes to choosing a market index for your annuity, you have quite a few choices. Most fixed indexed annuities are indexed on one of the major stock indexes: the S&P 500, the Nasdaq, or the Dow Jones. However, depending on where you buy it, you can also index an annuity on a smaller index, like the Nasdaq 100, Russell 2,000, Russell 3,000, S&P MidCap 400, or S&P SmallCap 600. With all of these choices, how do you make your decision?




Major Stock Indexes


With some annuities, you may not have a choice. Some issuing companies only offer S&P 500 fixed indexed annuities. That said, if you can choose from all of the options listed above, it can be tough to narrow it down. For most people, indexing your annuity on the S&P 500, the Nasdaq, or the Dow Jones is your best bet. These are the largest and most well-known market indexes, and you can typically expect them to have relatively steady growth throughout your accumulation phase.


The S&P 500, as the name implies, includes 500 major American companies from a diverse selection of markets and industries. Meanwhile, the Dow Jones is all about the heavy hitters, as it incorporates data from the 30 biggest companies in the U.S. today. Finally, the Nasdaq includes a much wider swath of companies, incorporating around 3,000 different businesses. For the most part, the Nasdaq is more technology-focused than the Dow Jones or the S&P 500.




Niche Indexes


If you have more specific investment goals, you might be interested in one of the lesser-known indexes. Let’s briefly walk through what some of these smaller market indexes have to offer.

The Nasdaq 100 cuts the Nasdaq’s roughly 3,000 companies down to the 100 biggest companies. This index is typically even more laser-focused on the tech sector than the broader Nasdaq index, as the Nasdaq 100 does not include any financial firms.

The Russell 2,000 focuses on small businesses. Because small-cap companies are often far more volatile than bigger businesses, there can be some significant fluctuations in a Russell 2,000 fixed indexed annuity. However, these stocks often outpace the growth of large-cap companies over the course of many years. If you still have plenty of time before retirement, indexing your annuity on the Russell 2,000 is an intriguing prospect.The Russell 3,000 adds the 1,000 largest American companies to the foundation of the Russell 2,000. This provides investors exposure to a wider swath of the overall market, while also typically generating steadier (if lower upside) returns.

The S&P 500 is only one part of the broader S&P 1500. The two lesser-known portions of the S&P 1500 are.

The S&P MidCap 400 includes only mid-sized companies, which are roughly defined as those with market caps somewhere in the range of $1.5 billion to $7 billion. The S&P MidCap 400 provides investors with lower volatility than a small-cap index but more long-term growth potential than you’ll typically find with big businesses.

The S&P SmallCap 600 is exactly what it sounds like: an index that tracks 600 small businesses. This index is quite similar to the Russell 2,000, although the S&P SmallCap 600 is much less popular.

In addition, you can split the S&P 500 itself into two smaller indexes:

The S&P 500 Value Index is mostly focused on legacy businesses in traditional market sectors, like banking stocks and oil and gas companies. This index provides a low upside, but it also has a relatively high floor.

The S&P 500 Growth Index is a bit harder to define, as there is no one set type of company that’s included. For the most part, the companies in the S&P 500 Growth Index have strong sales data and high earnings.



In Conclusion


There are quite a few different stock market indexes that you can index your annuity from. However, the vast majority of fixed indexed annuities issued today are indexed on the S&P 500, while most others are on the Nasdaq or the Dow Jones. Although, the lesser-known indexes we discussed aren’t nearly as popular for annuities, they all have some characteristics that make them worth considering for investors with specific goals and targets in mind.


Overall, when purchasing a fixed indexed annuity, it’s important to keep in mind that there are other crucial decisions to be made other than which market index you choose. The value of a fixed indexed annuity relies greatly on its cap, participation, or spread rates. In fact, these factors can affect the total value of your annuity even more than the market index.


If you have further questions, you should direct them to your independent insurance agent. In general though, if you’re looking for a fixed indexed annuity with strong growth potential and reasonably low risks, indexing your annuity on the S&P 500 is always a solid decision. After all, there’s a reason it’s the most popular option.