An indexed annuity is a type of annuity contract that pays an interest rate based on the performance of a specified market index, such as the S&P 500. It differs from fixed annuities, which pay a fixed rate of interest, and variable annuities, which base their interest rate on a portfolio of securities chosen by the annuity owner. Indexed annuities are sometimes referred to as equity-indexed or fixed-indexed annuities. Indexed annuities give buyers an opportunity to benefit when the financial markets perform well, unlike fixed annuities, which pay a set interest rate regardless.
However, certain provisions in these contracts can limit the potential upside to only a portion of the market’s rise.
How Indexed Annuities Work
Indexed annuities offer their owners, or annuitants, the opportunity to earn higher yields than fixed annuities when the financial markets perform well. Typically, they also provide some protection against market declines.

The rate on an indexed annuity is calculated based on the year-over-year gain in the index or its average monthly gain over a 12-month period.

While indexed annuities are linked to the performance of a specific index, the annuitant won’t necessarily reap the full benefit of any rise in that index. One reason is that indexed annuities often set limits on the potential gain at a certain percentage, commonly referred to as the “participation rate.” The participation rate can be as high as 100%, meaning the account is credited with all of the gain, or it as low as 25%. Most indexed annuities offer a participation rate between 80% and 90%—at least in the early years of the contract.

For example, if the stock index gained 15%, an 80% participation rate translates to a credited yield of 12%. Many indexed annuities offer a high participation rate for the first year or two, after which the rate adjusts downward. In addition, most indexed annuity contracts also include a yield or rate cap that can further limit the amount that’s credited to the accumulation account. For example, a 7% rate cap limits the credited yield to 7% no matter how much the stock index gained. Rate caps typically range from a high of 15% to as low as 4% and are subject to change.

In the example above, the 15% gain reduced by an 80% participation rate to 12% would be further reduced to 7% if the annuity contract specifies a 7% rate cap.