The indexed annuity, also known as an equity indexed annuity, or a fixed indexed annuity, can be thought of as sitting in the financial territory between the fixed annuity and the variable annuity.
Like a fixed annuity, an indexed annuity offers a minimum, fixed guaranteed rate of return.
Like a variable annuity, an indexed annuity has upside potential, because it is tied to the performance of a stock index, such as the S&P 500.
The Indexed Annuity Concept – the annuity is linked to a stock index. The annuity shares some of the gains when the index rises, but does not lose value when the index falls
It should be pointed out that, as a result of financial innovation, it is possible to change the way standard annuity types work. So, because of customer demand, fixed annuities can actually offer increasing payouts each year, if you are willing to accept a smaller initial payout. Similarly, variable annuities can actually offer a guaranteed minimum monthly income, if again you are willing to pay the extra fee for this arrangement.
Fixed annuities are the easiest of the annuity types to understand. Your money is placed in the general insurance company fund, and this provides a guaranteed return until the end of your annuity term.
Variable annuities are seen as more complex. Their performance is tied to mutual funds. Selling of variable annuities is regulated by the SEC.
Despite the possibly even greater complexity of indexed annuities, most have escaped regulation by the SEC. Even greater caution is therefore advised when considering buying an indexed annuity.
An indexed annuity will offer a guaranteed minimum rate of return. The guaranteed minimum return is usually 87.5% or more of the premium paid to buy the annuity plus 1 to 3 percent interest added every year. The higher these numbers are, the better.
The gain available from an indexed annuity is lower than would be available from investing in the underlying stocks because:

In most cases, the annuity is linked to a capital index, such as the S&P 500, which does not add company dividends to its value.

Only a percentage of any gain in the index is allocated to your annuity. Your annuity might get 75% or 90% of the value in the rise of the index, for example. This is called the participation rate.

As an alternative to, or in combination with the participation rate, the insurance company might subtract a fixed percentage from any gain. For example, 3% might be deducted from any index gain, reducing a 9% rise in the stock index to a 6% rise in your annuity. This is called the spread or margin or asset fee.

Also watch out for absolute limits which could be placed on the percentage gain your annuity will be allowed. For example, the S&P 500 index might have an exceptional year and rise 30%. If your gain is capped at 10%, you will only benefit from onethird of the index’s gain.
Before you sign an indexed annuity agreement, look out for limits placed on your upside potential. There have to be some, because the insurance company is limiting your downside risk. You can’t expect a free lunch. Shop around for the best deal, which gives you the best possible return when the index your annuity is linked to rises. Also look out for annuity agreements that allow the insurance company to change the terms. You don’t want to wake up one morning and find your participation rate has been reduced.
If you cash in your annuity earlier that the agreed period, you will most likely be charged a large surrender fee. You will also pay 10% extra tax on your investment gains if you cash in before you are aged 59.5 years.