What an annuity invests in depends entirely on the type. Fixed annuities are backed by an insurance company’s portfolio of bonds and mortgages. Variable annuities let you choose from stock, bond, and money market funds. Indexed annuities don’t directly invest in the market at all, but tie your returns to the performance of a stock index. Here’s how each type works under the hood.
Fixed Annuities: Bonds and Mortgages
When you buy a fixed annuity, your money goes into the insurance company’s “general account,” a large pool of conservatively managed assets. The company promises you a guaranteed interest rate, and it earns enough to pay that rate by investing the pool primarily in high-quality corporate and government bonds. Investment-grade bonds account for about 95% of total bond holdings across the life insurance industry, according to the National Association of Insurance Commissioners.
Beyond bonds, general accounts typically hold commercial mortgage loans, real estate, and smaller allocations to other fixed-income instruments. The key point for you: none of this is your decision. The insurance company picks the investments, manages the risk, and guarantees your rate regardless of how the portfolio performs in any given quarter. Your return is locked in by contract, not by market performance.
State insurance regulators require companies to diversify these holdings by type, issuer, industry, and geographic location. They also impose liquidity requirements so the company can always meet its obligations to policyholders. That regulatory framework is a big part of why fixed annuities carry lower risk than other types.
Variable Annuities: Funds You Choose
A variable annuity works more like a retirement account with a menu of investment options. Your premiums go into “subaccounts,” which function similarly to mutual funds. You pick from stock subaccounts, bond subaccounts, money market subaccounts, or a mix of all three. The rate of return varies based on how those subaccounts perform, which is where the name comes from.
A typical variable annuity might offer 20 to 80 subaccount choices spanning large-cap stocks, international equities, government bonds, corporate bonds, real estate funds, and stable-value options. You can usually reallocate your money among subaccounts without triggering a taxable event, since annuities grow tax-deferred. But unlike a fixed annuity, there’s no guaranteed return. If your chosen subaccounts lose value, your account balance drops. The investment risk sits with you, not the insurance company.
Many variable annuities offer optional riders (add-on guarantees you pay extra for) that provide a minimum income floor or a death benefit regardless of market performance. These riders come with annual fees, often 0.5% to 1.5% of your account value on top of the base contract charges.
Indexed Annuities: Linked to an Index, Not Invested in One
Fixed indexed annuities occupy a middle ground that confuses a lot of people. Your returns are tied to a stock market index like the S&P 500, but you don’t actually own any of the underlying securities. The insurance company keeps your premium in its general account (bonds, mortgages, the same conservative mix behind fixed annuities) and uses a portion of the earnings to buy options contracts that track the index’s movement.
This structure means you participate in some of the market’s upside without being directly exposed to its downside. In exchange, the insurance company limits how much of the index gain you actually receive. Three mechanisms control this:
- Cap: A ceiling on your return. If the index gains 10% but your cap is 5%, you get 5%.
- Participation rate: The percentage of the index return credited to your account. An 80% participation rate on an 8% index gain gives you 6.4%.
- Spread: A fixed percentage subtracted from the index return before you receive anything. If the spread is 2% and the index gains 7%, you get 5%.
Your contract may use one of these mechanisms or a combination. Returns also generally exclude dividends, which historically make up a meaningful portion of total stock market returns. So even in a strong market year, your credited return will trail the index’s full performance. The trade-off is downside protection: most fixed indexed annuities guarantee you won’t lose principal due to market declines, though surrender charges can still eat into your balance if you withdraw early.
Registered Index-Linked Annuities: A Newer Option
Sometimes called “buffer annuities,” these products work similarly to fixed indexed annuities but with a twist. Instead of fully protecting you from losses, the insurance company absorbs a set percentage of downside (the “buffer,” often 10% to 20%) and passes losses beyond that threshold to you. In return, you typically get higher caps or participation rates than a traditional indexed annuity would offer. Like indexed annuities, your money isn’t directly invested in the index. The returns are calculated based on index performance, but the underlying assets remain in the insurer’s general account.
Why the Annuity Type Matters More Than the Assets
With a fixed or indexed annuity, you never interact with the underlying investments. The insurance company handles everything and gives you a contractual guarantee. Your real concern isn’t what’s in the portfolio but whether the insurance company is financially strong enough to honor its promises. Checking the insurer’s ratings from agencies like A.M. Best or S&P gives you a sense of that strength.
With a variable annuity, you’re making active investment decisions and bearing market risk. The subaccounts you select determine your returns, and poor choices or bad timing can shrink your balance. The upside is that strong market performance flows directly to your account, minus fees.
In all cases, annuity assets grow tax-deferred, meaning you don’t pay taxes on gains until you withdraw money. Withdrawals before age 59½ typically trigger a 10% early withdrawal penalty on top of ordinary income tax. This tax treatment is identical regardless of whether the underlying investments are bonds in a general account or stock subaccounts you picked yourself.