What is an indexed annuity and why are they so popular?
For those who want guaranteed retirement income, the indexed annuity has become one of the most popular options.
Indexed annuities made up 45% of all annuity sales in 2025, according to LIMRA, a trade association for the insurance and financial services industry.
That represents a significant increase in market share in the past decade.
Retirees often turn to these types of annuities because they want the potential growth of an annuity tied to the stock market without the risk of seeing their principal disappear in a market downturn.
For many retirees, traditional fixed annuities offer returns that are too modest, while variable annuities pose the risk of market losses.
Indexed annuities offer a middle ground — the ability to participate in market gains while still getting downside protection.
However, that doesn’t mean they are right for everyone. It’s important to understand the pros and cons of these vehicles before you make what may be a long-term financial decision.
What is an indexed annuity? The basics explained
An indexed annuity is a contract you establish with an insurance company that provides you with a payout based in part on the performance of a market index.
This type of annuity consists of two phases.
During the accumulation phase, you pay a lump sum or make periodic payments to the insurer. Your returns are tied in part to the performance of one or more market indices, such as the S&P 500 index.
This is the phase where your savings grow tax-deferred based on the performance of the underlying index.
During the annuity phase, the insurer typically makes payments to you over a pre-specified period. In some cases, the money might be paid out as a lump sum.
A key feature of many indexed annuities is protection against market-related losses to principal. In exchange for this protection, you accept lower potential gains than you might get with a variable annuity.
While variable annuities allow you to directly invest in securities, indexed annuities allow you to accumulate index-linked interest credits. With the latter type of annuity, the contract typically includes a guaranteed minimum interest rate — often between 1% and 3%.
In short, with a variable annuity, you bear the risk but also have the potential for a higher payout. With an indexed annuity, the insurer assumes much of the downside market risk.
The downside protection of indexed annuities makes them attractive to retirees who want the chance at higher income while also limiting losses.
How does an indexed annuity work? Understanding the mechanics
Before deciding to purchase an indexed annuity, it helps to understand how these retirement income sources work.
Index selection and crediting methods
Each indexed annuity is tied to one or more market indices. Perhaps the best-known and most popular such index is the S&P 500 index, which tracks the performance of 500 large publicly traded companies in the U.S.
However, other annuities may be tied to another index, such as the Nasdaq-100, which is heavily weighted toward technology companies. And some annuities may use a variety of index options.
You also may be allowed to choose from a variety of indices.
The performance of the index will determine your own gains. The better the market does, the higher your returns are likely to be.
The three key limiting factors
The annuity you choose may be subject to caps, participation rates, and spreads.
The cap rate established in your annuity contract will determine how much interest you reap from strong market performance.
So, if the index returns 20% and your cap rate is 7%, you will be credited with 7% of that gain. On a more positive note, if the index declines by 10%, you typically will not experience a loss of credited interest.
On the other hand, a participation rate establishes a percentage of the index gain that will be credited to an annuity. If your participation rate is 90%, you will earn credit for that much of the index gain over the year.
Finally, a spread subtracts a pre-specified percentage from the index return, and credits you with that amount of interest. If the market gains 10% and your spread deduction is 5%, you would be credited with a 5% return.
It is important to understand that these numbers are not set in stone. Some indexed annuities adjust such percentages annually, while others do not.
Guaranteed minimum returns
Most indexed annuities guarantee that you will receive a minimum return. This is typically between 1% to 3% on at least 87.5% of the premium paid.
This is the feature that many retirees love most about indexed annuities. Even if the markets tank for an extended period, annuitants still receive a minimum return and generally do not experience a loss of principal due to market performance.
For example, let’s say you invest $200,000 in an indexed annuity with an 87.5% minimum guarantee at 1% annually over 10 years. Even if the index were to completely tank and leave you with zero credited interest, you would still get a value of at least $218,700.
Why indexed annuities are the top-selling annuity type
As mentioned above, indexed annuities are the biggest-selling annuity type, with sales representing almost half of the annuity market.
Several factors explain the popularity of indexed annuities.
Five attractive features driving popularity
1. Market participation with principal protection
Most years, people who invest in stocks are rewarded with solid returns. But that is not always the case.
Major bear markets that began in 2000, 2007 and 2020 all decimated the portfolios of millions of investors. In each case, the stock market went on to recover nicely, but such shocks can be scary for retirees living off their nest egg.
With an indexed annuity, you are able to participate in some of the stock market gains while avoiding most of its losses.
2. Competitive returns compared to traditional fixed annuities
If you purchase a traditional fixed annuity, you may receive a credit of somewhere between 4% and 6% annually, depending on term length. In recent history, rates were even lower.
Indexed annuities offer the potential to exceed those returns if markets do well in the future.
3. Tax-deferred growth
Annuities typically offer the advantage of tax-deferred growth, and indexed annuities are no exception.
Deferring taxes allows you to compound gains without having the process interrupted by the need to give up some of your returns to Uncle Sam and your state government.
In addition, some people make enough money to quickly exhaust the tax advantages available in 401(k) plans and IRAs. For these high earners, annuities offer an additional place to earn tax-deferred returns.
4. Optional living benefit riders
Many indexed annuities offer a rider known as an optional guaranteed lifetime withdrawal benefit (GLWB). This allows you to make guaranteed yearly withdrawals no matter how the stock market performs.
For a fee, you might receive guaranteed withdrawal rights of 5% to 6% of a benefit base that grows by 6% to 7% annually until you activate income.
Thus, you get growth potential during accumulation with annuity income certainty later.
5. Death benefit protection for beneficiaries
With most investments, your heirs will receive only what your investment account is worth at the time of your death. If you die in the middle of a major bear market, the payout to your heirs might be substantially less than you planned.
By contrast, indexed annuities typically guarantee beneficiaries to receive at least the premium paid, or the current account value if it is greater. In addition, some annuities offer enhanced death benefits of 5% to 7% in annual step-ups.
The psychological appeal factor
Annuities have always appealed to retirees who want to dial back on risk by ensuring guaranteed income. But indexed annuities offer the additional appeal of allowing you to capture some of the market upside while also protecting you from the market downside.
It’s important to note that insurance agents and broker-dealers also have a vested interest in selling indexed annuities to you. That is because they tend to earn much larger commissions on indexed annuities than on other annuity products.
Critical drawbacks and considerations before purchasing
Indexed annuities may sound terrific, and they can be the right choice for some people. But they also come with drawbacks.
Indexed annuities often involve moderate fees — often higher than those of fixed annuities, but lower than those of variable annuities. As a general rule, annuities have higher fees than other investments.
Here are some additional drawbacks of indexed annuities:
Liquidity constraints and surrender charges
Most indexed annuities come with surrender charges of 7% to 10% for seven to 10 years. Fortunately, these charges decline gradually over time.
However, if you withdraw more than the penalty-free amount (typically 10% annually), you may incur significant penalties.
Capped growth limits long-term accumulation
Although indexed annuities allow you to capture some of the market’s upside, caps and participation rates significantly limit your gains.
Some people are happy to make this tradeoff in exchange for knowing they are protected from market losses. But historically, during strong bull markets, you will earn less in an annuity than you would have if you chose to invest in an index fund yourself outside of an annuity.
Complexity and lack of transparency
Indexed annuity contracts can be confusing. People who purchase this type of annuity often do not understand things such as crediting methods, cap adjustment provisions, and minimum guarantee formulas.
In addition, indexed annuity costs are often baked into caps, spreads, and participation rates. This can make these costs harder to understand than the clear, simple expense ratio you will find with most mutual funds.
Inflation risk over extended periods
One of the biggest drawbacks of annuities is the possibility that over time, inflation will outrun the income your annuity provides.
Although indexed annuities allow you to capture some of the market return, it is still possible that your annuity income will lag in periods of high inflation.
Advisor compensation and potential conflicts
As mentioned earlier, high commission structures for insurance agents and broker-dealers may create an incentive to recommend indexed annuities.
For this reason, it’s important to ask about and understand compensation structures. Also, consider working with fee-only fiduciary advisors who don’t earn commissions on product sales.
Is an indexed annuity right for you?
Indexed annuities can be the right choice for some retirees. Another type of annuity may better serve others, or skipping annuities altogether.
Everyone’s financial needs and goals are different. For that reason, it makes sense to sit down with a fee-only financial advisor who can help you craft a retirement income strategy that may or may not include indexed annuities.
The key is understanding how the trade-offs between growth, protection, liquidity, and cost fit into your overall plan.
