Indexed Annuity Gettyimages
Image source: Getty Images.

This is Part 5 in a six-part series on annuities. Part 1, an introduction to annuities, can be found here.

Indexed annuities, also known as fixed-indexed annuities or equity-indexed annuities, have surged in popularity in recent years because of the way they incorporate features beyond those found in conventional fixed annuities.

Similar to fixed annuities, those who buy indexed annuities are often guaranteed returns. But, unique to indexed annuities, a portion of those returns may vary because they are linked to a specific market index, such as the S&P 500. As a result, the return on fixed indexed annuities generally may be higher or lower than the guaranteed rate of return on conventional fixed annuities.

In addition, indexed annuities as with conventional fixed annuities aren't subject to taxes until you begin receiving distributions from your annuity.

Sales of indexed annuities by insurance companies and broker-dealers spiked in 2015 to $54.5 billion, up from $48.2 billion in 2014, according to insurance and financial research group LIMRA.

Their popularity notwithstanding, indexed annuities are complex financial instruments and retirement experts warn that such annuities include a number of features that may result in lower returns than an investor might expect.

"While they allow you to participate in market gains on a tax-deferred basis while protecting you from losses ... they can seriously limit your upside," wrote Real Deal Retirement editor Walter Updegrave.

Here's how a fixed indexed annuity works: The returns (in the form of interest credited to the contract) can consist of a guaranteed minimum interest rate and an interest rate linked to a market index.

The guaranteed minimum interest rate usually ranges from 1% to 3% on at least 87.5% of the premium paid. As long as the company offering the annuity is fiscally sound enough to meet its obligations, you will be guaranteed to receive this return no matter how the market performs.

Your index-linked returns will depend on how the index performs but, generally speaking, an investor with an indexed annuity will not see his or her rate of return fully match the positive rate of return of the index to which the annuity is linked -- and could be significantly less. One major reason for this is that returns are subject to contractual limitations in the form of caps and participation rates.

Participation rates are the percentage of an index's returns that are credited to the annuity. For instance, if your annuity has a participation rate of 75%, then your index-linked returns would only amount to 75% of the gains associated with the index.

Interest caps, meanwhile, essentially mean that during big bull markets, investors won't see their returns go sky-high. For instance, if an index rises 12%, but an investor's annuity has a cap of 7%, his or her returns will be limited to 7%.

Some indexed annuity contracts allow the issuer to change these fees, participation rates and caps from time to time. One indexed annuity customer, for instance, found the cap on her annuity was 8% the year she bought it, but dropped to 6% five years later, Bloomberg reported.

Investors should also be aware that trying to withdraw the principal amount from a fixed indexed annuity during a certain period -- usually within the first nine or 10 years after the annuity was purchased -- can result in fees known as surrender charges, and could also trigger tax penalties. In fact, under some contracts if withdrawals are taken amounts already credited will be forfeited. The result: after paying surrender charges an investor could actually lose money by surrendering their indexed annuity too soon.

As with any investment, when considering an indexed annuity, it's important to do your research and thoroughly review the contract for the product being offered to you to determine whether it meets your needs.

For more information, you can also check out the Financial Industry Regulatory Authority's Investor Alert titled Equity-Indexed Annuities: A Complex Choice.

An Alert Investor is a smarter investor.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.