How Does an Indexed Annuity Differ From a Fixed Annuity? A Guide for US Expats

For US expats, the comparison does not end with returns and risk. Living abroad can introduce additional considerations around taxation, treaty treatment, reporting, currency exposure and whether an insurer will continue to service or modify a contract after you relocate.

This guide compares US fixed deferred annuities and fixed indexed annuities and explains the additional issues to consider if you own, or are considering, a US annuity while living overseas.

How Do Indexed Annuities Compare to Fixed Annuities in Terms of Returns?

A fixed annuity provides a predetermined interest rate for a specified period. Depending on the contract, the rate may be guaranteed for a defined period, after which renewal rates may change subject to contractual minimums. In contrast, an indexed annuity links returns to the performance of an underlying market index.

This difference results in distinct outcomes and features:

Due to its return dynamics, an indexed annuity is generally considered a midpoint between a fixed and a variable annuity that exposes you to more direct market risk (and therefore more pronounced return fluctuations).

In contrast to a variable annuity, an indexed annuity does not invest your account value directly in the market index. Rather, it utilises the index as a reference against which interest will be credited. Consequently, it limits direct exposure to market losses while still allowing for a certain degree of participation in positive index performance.

An indexed annuity is also referred to as a “fixed indexed annuity (FIA).” This nomenclature can be confusing, so it is important to separate this product from a traditional fixed annuity, which credits interest according to fixed contractual terms rather than the performance of an equity index.

It is also important not to confuse a traditional fixed indexed annuity with other index-linked annuity structures that can expose the contract holder to defined market losses. Their downside mechanics and regulatory treatment can differ materially.

What Is the Difference Between Fixed and Indexed Annuities?

Fixed and indexed annuities differ in seven fundamental aspects:

1. Growth potential
2. Downside protection
3. Risk level
4. Complexity
5. Fees
6. Liquidity considerations
7. Inflation protection

Growth Potential

Considering that the credited rate of a fixed annuity is set in advance for a specified period, it is typically moderate and predictable during that period. In strong market conditions, fixed annuities may provide considerably lower returns than indexed annuities, whose return profile is connected to the selected benchmarks.

This distinction has several practical implications to consider if you wish to purchase an indexed annuity rather than a fixed one. Although indexed annuities offer greater potential to benefit from market growth, their returns are:

• Not guaranteed in the long term.
• Potentially minimal in flat or declining markets.
• Typically lower than the return available from directly holding the securities represented by the index during strongly rising markets.

From the return perspective, the decision between a fixed and indexed annuity essentially revolves around predictability versus growth potential and the corresponding risks. Investors with sufficient growth assets may select a fixed annuity and vice versa, so it is essential to consider the remainder of your portfolio.

Downside Protection

Fixed annuities provide a high degree of downside protection against market movements. The account is not directly exposed to stock market declines, so its credited value does not fall merely because equity markets decline. If capital preservation is your primary objective, this can provide considerably greater certainty than investing directly in market assets.

However, this does not mean the contract is entirely free from the possibility of loss. Withdrawals, surrender charges and other applicable contract terms can reduce the amount received, and contractual guarantees remain dependent on the issuing insurer’s claims-paying ability.

A traditional fixed indexed annuity also generally provides contractual protection against negative index performance. Because your funds are not invested directly in the reference index, a decline in that index does not normally produce an equivalent decline in the contract value.

This does not mean every possible loss is eliminated. Withdrawals, surrender charges and other contractual provisions may reduce the amount you receive, while the guarantees themselves depend on the financial strength and claims-paying ability of the insurer.

The contract value is therefore generally protected from reductions caused solely by negative index performance under the terms of a traditional fixed indexed annuity, which is one reason these products may still be suitable for investors seeking indirect market exposure without assuming the same downside risk as a direct investment.

Other index-linked annuity structures can work differently and may expose the contract holder to a defined proportion of market losses. You should therefore check the precise product classification and contractual loss provisions rather than assuming that every index-linked annuity provides the same level of capital protection.

Risk Level

Fixed annuities do not expose the contract value directly to stock market movements. The applicable fixed return is determined by the contract, though this certainty may be offset by comparatively lower growth potential. They may therefore be suitable for conservative investors who prioritise predictable returns and capital preservation over market-linked growth.

The crediting mechanics of an indexed annuity introduce an additional layer of uncertainty because the amount of interest credited can vary according to index performance and the contract’s crediting terms. This is moderated because:

• Traditional fixed indexed annuities generally protect the contract value against direct losses caused by negative index performance.
• Contracts may include floors or other protective features.
• There is no full participation in the underlying market.

Indexed annuities may therefore be suitable for investors with limited tolerance for market volatility who nevertheless want some potential to benefit from positive market performance. Suitability depends on more than risk tolerance, however. Liquidity needs, investment horizon, retirement income requirements, tax circumstances and the role of the annuity within the wider portfolio should also be considered.

Both types expose you to issuer credit risk, considering that contractual guarantees depend on the provider’s financial strength and claims-paying ability. If the insurer becomes insolvent, the contract holder may not receive all amounts otherwise guaranteed under the contract.

In the US, annuities are not protected by federal deposit insurance in the same way as bank deposits. State insurance guaranty associations may provide limited protection following an insurer insolvency, subject to the applicable state rules and coverage limits.

Complexity

Fixed annuities require relatively little technical interpretation compared with indexed products. The applicable rate and guarantee period are stated in the contract, although renewal rates, surrender provisions and other contractual terms still need to be understood.

By contrast, indexed annuities introduce several complexities, most notably:

• Caps, floors, spreads and participation rates.
• Various indexing and crediting methods.
• Performance prediction challenges.

Features embedded in an indexed annuity may result in lower returns than expected, so understanding the relevant terms is important. If you have not utilised similar products, it is recommended to consult a financial expert before purchasing an indexed annuity.

Fees

Fixed annuities seldom have separate administrative or investment management fees. The rate offered by the insurer generally takes account of the economics and costs of providing the contract, although specific charges and optional features depend on the product.

Although an indexed annuity may also be marketed without an explicit annual management fee, this does not mean the contract allows unrestricted participation in index returns. Caps, participation rates and spreads can all reduce the amount of positive index performance ultimately credited to the contract.

These are not necessarily fees in the same sense as a direct management charge, but they affect the return you receive. It is therefore prudent to account for them when determining the cost-effectiveness and potential return of an indexed annuity.

Liquidity Considerations

Neither fixed nor indexed annuities are designed for short-term access to capital. They are generally medium- to long-term contracts, and early withdrawals or surrenders can result in significant charges or reduced proceeds.

The consequences depend on the contract:

1. Fixed annuities: Early withdrawals may incur a surrender charge and can also have tax consequences.
2. Indexed annuities: Besides a potential surrender charge, a withdrawal may affect index-linked interest that has not yet been credited for the current crediting period, depending on the contract terms.

For US taxpayers, distributions from certain annuity contracts can also produce additional federal tax consequences, including an additional tax on the taxable portion of some distributions made before age 59½ unless an exception applies.

If you anticipate needing immediate access to capital, neither annuity type may be suitable. Either maintain liquidity through other investments or review the surrender charge schedules and withdrawal provisions to ensure you are comfortable with them, should you need to access the capital.

Inflation Protection

Inflation hedging is not the primary objective of either fixed or indexed annuities, although the latter may provide greater potential to preserve purchasing power because its returns are linked, in part, to the performance of a market index.

By contrast, a fixed nominal rate creates purchasing-power risk when inflation exceeds the return credited to the annuity. This means other assets may be needed alongside an annuity if maintaining purchasing power is an important objective.

Even an indexed annuity cannot guarantee inflation protection. Market performance, participation rates, return caps, spreads and other contractual limits may reduce credited returns, limiting the annuity’s ability to preserve purchasing power over the long term.

Which Factors Impact the Performance of Indexed Annuities?

Although the performance of an indexed annuity is tied to an underlying index, it may differ significantly from its reference. Consequently, the rate of return credited to an indexed annuity does not necessarily match the positive return of the index.

The index is used as a reference for calculating interest rather than being an investment that you own directly. Depending on the index and contract, the calculation may also differ from the total economic return an investor would receive from directly holding the underlying securities.

There are several factors contributing to this potential gap, most notably:

1. Participation rates
2. Caps and spreads
3. Different crediting and averaging methods

Participation Rates

Considering that your investment is not directly placed into the market when you purchase an annuity, you may not receive the index’s entire growth. Rather, your investment grows according to the set participation rate, which is the percentage of the relevant index gain used to determine the interest credited to your account.

Below is an illustrative example:

• Participation rate: 85%
• Market growth: 20%
• Credited rate: 17% (85% x 20%)

This example assumes no other contractual limit applies.

The insurer may guarantee a participation rate for a set period, after which the contract may allow it to be adjusted. The permitted frequency and extent of any changes should be set out in the contract.

These potential changes introduce a degree of complexity and unpredictability. If the participation rate declines, your annuity may grow at a slower pace even when its reference index performs strongly.

Caps and Spreads

A return cap sets the upper limit on the interest rate that your annuity may earn from the relevant index-crediting strategy during a crediting period. Regardless of how much the market rises, you may only receive returns up to the defined cap.

Although this may have little effect when index growth remains below the ceiling, a low cap can result in forgoing a substantial part of the index’s gain during strong market periods.

Some contracts instead use, or may also incorporate, a spread. A spread is a predetermined percentage deducted when calculating the index-linked interest credited under the relevant strategy.

Participation rates, caps and spreads can therefore cause your annuity to perform very differently from the index. Their precise interaction is contract-specific, so they should not be assumed to apply in a particular order.

For example, if an index rises by 15% but the applicable strategy has a 9% cap, the maximum index-linked interest credited under that strategy would be 9%, irrespective of the additional market growth. A different strategy using an 80% participation rate without that cap would credit 12% before any other applicable contractual adjustment.

Annuity contracts may contain caps, participation rates or spreads individually or in combination. Some contracts also allow these terms to change periodically within specified contractual limits, which can further complicate long-term projections.

Different Crediting and Averaging Methods

An insurer might credit your interest according to the annual point-to-point method, in which your return is calculated by comparing the index value at the start of the crediting period with its value at the end. Other contracts use averaging or monthly methods instead.

Two examples are:

Depending on market performance, different crediting methods can result in significantly different outcomes. A sharp movement near the end of a crediting period, for example, can have a greater effect on an annual point-to-point calculation than on a strategy based on averaging.

This is why headline index performance alone tells you relatively little about the return an indexed annuity will actually credit. The participation rate, cap, spread and crediting method all need to be considered together.

Should You Invest in a Fixed or Indexed Annuity?

Neither a fixed nor an indexed annuity is universally superior or better suited for your portfolio. Risk tolerance and investment objectives are important, but they are not the only considerations:

If you prefer contractual certainty over growth potential and have already accumulated sufficient capital that you wish to protect from market volatility, a fixed annuity may be sensible. By contrast, investors with a longer investment horizon who want greater growth potential than a traditional fixed annuity may consider an indexed annuity.

The choice should also reflect your income needs, liquidity requirements, time horizon, tax circumstances and other assets. An investor who may need substantial access to the capital during a surrender period, for example, may reach a different conclusion from an investor who expects to hold the contract for its intended term.

You should also consider whether the annuity is intended primarily to accumulate capital, provide future retirement income or complement other sources of predictable income. Those objectives can affect which contract features matter most.

If you require guidance, Titan Wealth International can provide it. Our financial advisers can review your portfolio, assess the suitability of an annuity, and help you understand its features.

What Should US Expats Consider Before Purchasing or Holding an Annuity?

Besides the factors that domestic investors should consider when investing in an annuity, US expatriates and internationally mobile annuity holders should also account for:

1. Product availability while living abroad.
2. Cross-border taxation of annuity income.
3. US and local reporting obligations.
4. Currency risk.
5. Impact of relocation on ownership and taxation.

For US expatriates, citizenship and US tax status can remain relevant even after establishing residence in another country. Your country of residence, the jurisdiction in which the annuity was issued and the classification of the particular contract can also affect its tax and reporting treatment.

Product Availability for Non-Residents

Purchasing or changing a US annuity while living abroad can be difficult due to provider and regulatory limitations.

US insurers may impose restrictions due to:

• State-level insurance licensing requirements.
• Internal compliance policies.
• Lists of jurisdictions in which products cannot be offered or serviced.

Although you may identify insurers catering to clients living abroad, you should be prepared for additional contract requirements and reporting considerations. Product availability should therefore be checked before purchasing an annuity or relocating to another country.

Cross-Border Taxation of Annuity Income

US expatriates should consider both the US tax treatment of annuity income and any obligations arising in their country of residence. Depending on where you live, the same payment may be subject to the tax rules of more than one jurisdiction.

US citizens and certain US tax residents can remain subject to US tax on worldwide income after moving abroad. US tax treaties commonly contain a savings clause preserving the US right to tax its citizens and residents, subject to treaty-specific exceptions. This can create taxation in more than one jurisdiction, although foreign tax credits and applicable treaty provisions may reduce or eliminate double taxation.

For example, a US annuity holder who becomes a UK tax resident may also need to consider UK taxation and the provisions of the UK-US double taxation agreement. The outcome can depend on the classification of the annuity and the nature of the payment, so the relevant treaty provisions and domestic tax rules need to be considered together.

Reporting Obligations in Different Jurisdictions

Living abroad does not, by itself, remove US tax filing or reporting obligations for US citizens and other persons who remain within the US tax system. Depending on the circumstances, local reporting obligations may apply as well.

The reporting position also depends on where the annuity is issued. For instance, a US expat who holds a foreign-issued annuity or other foreign financial assets may need to consider several separate US reporting regimes:

• Form 8938 (FATCA): Certain US taxpayers must report specified foreign financial assets when their aggregate value exceeds the applicable threshold. For qualifying taxpayers living abroad, the threshold is generally more than $200,000 on the last day of the tax year or $300,000 at any point during the year for taxpayers filing other than jointly. For married taxpayers filing jointly and living abroad, the corresponding thresholds are generally $400,000 and $600,000.
• FBAR: A foreign annuity policy with cash value can constitute a foreign financial account. An FBAR is generally required if the aggregate value of reportable foreign financial accounts exceeds $10,000 at any time during the calendar year, subject to applicable exceptions.
• Form 8621: Certain foreign investment structures can create passive foreign investment company (PFIC) reporting where a US person is treated as directly or indirectly owning PFIC shares. Whether a foreign annuity creates PFIC exposure depends on the legal and US tax classification of the contract and its underlying arrangement rather than simply on whether the insurer invests in foreign funds.

These regimes are separate. Filing an FBAR, for example, does not necessarily remove a Form 8938 obligation where the relevant requirements are met.

A US-issued annuity should not be assumed to create these foreign-asset reporting obligations merely because its owner subsequently moves abroad. The reporting analysis depends on the particular asset and the holder’s circumstances.

Currency Risk

If your US annuity income is denominated in dollars while your expenses arise in another currency, exchange rate fluctuations may significantly affect your purchasing power. A strengthening local currency may effectively reduce the value of dollar-denominated income available to meet those expenses.

Unmanaged currency exposure can undermine the predictability of annuities, particularly fixed products, so the currency in which future expenses will arise should be considered when deciding how an annuity fits into a retirement plan.

Impact of Relocation on Ownership and Taxation

Moving abroad can considerably complicate an existing US annuity contract. Besides encountering a new tax regime, you may face administrative restrictions such as:

• Restrictions on certain account changes.
• Limited ability to add or alter contractual features.
• Complications regarding cross-border payments.

The precise consequences depend on the provider, the contract and the country to which you move. A contract that was straightforward to administer while you were resident in the US may become more complicated after relocation.

Tax treatment can also change without the underlying annuity changing at all. A move can alter your local tax residence, treaty position, reporting obligations and the currency in which you meet everyday expenses. US annuity holders planning to move abroad should therefore review existing contracts as part of their wider planning before, rather than only after, a relocation.