by D. Victor

Created on: August 07, 2009   Last Updated: June 04, 2010

A Fixed Index Annuity (also equity-indexed annuity) is a special type of fixed annuity contract that fuses the safety of fixed annuities with higher participation in the financial market. Strictly speaking, it is not an investment- as it is primarily an annuity contract between an annuity investor and insurer or annuity provider. Although Fixed Index Annuities represent an improvement on fixed rate annuities, they inevitably have their merits and demerits.

Guarantees

Fixed Index Annuities- like other insurance contracts- offer investors guarantees on their premiums and returns. Apart from safety assurances for contributions, Fixed Index Annuities offer investors minimum (base) guaranteed rates of return. This suggests that even though their performance is linked to an external index, the annuities are insulated from severe downturns in the market.

One drawback of the guarantees is that investors may still lose money because the amount guaranteed on Fixed Index Annuities may lag behind the amount invested in the initial stages. It may take years for the guaranteed amount and the contribution level to merely "break even." In addition, the Fixed Index Annuity is only as safe as the annuity provider that you enter the contract with is.

Market-type returns

A major benefit of equity-indexed annuities is that they offer returns that link to market performance through an external index (such as the S&P 500). Annuity investors on this plan can benefit from favourable fluctuations in the market while being insulated from sharp downturns. Fixed Index Annuities also offer higher returns than fixed rate annuities, CDs and Money Market Funds.

While this is an obvious benefit, the annuity contract determines how much this benefit trickles down to the Fixed Index Annuity investor. Interest rate caps, margins and participation rates are features of this contract that determine how much the annuity contributor benefits. The method of indexing can also minimize or increase this benefit. How the FIA is indexed can play a huge role in determining whether market-type returns is a token benefit or not.

Taxation

Qualified equity-indexed annuities benefit from tax-deferred growth in the accumulation phase. Tax-deferred growth with eventual income taxation is far superior to accumulation with lower taxation. The downside to this tax benefit is that tax authorities treat annuity payments and distributions as income and not capital gains. As a result, the income tax bracket is applied

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