Annuities may be an option for retirement income

A Annuities seem to once again be gaining popularity as more investors look for ways to ensure a comfortable and predictable stream of retirement income. In the course of being inundated with sales pitches, glossy brochures, and myriad advertisements, however, it is critical to understand the basics of how an annuity contract works.

There are basically only two classes, or types, of annuities: deferred and immediate. A deferred annuity accumulates income on a tax-deferred basis. Conversely, an immediate annuity distributes income until the death of the annuitant, while frequently offering to beneficiaries guarantees of income that extend beyond the life of the annuitant. A deferred annuity can be exchanged on a tax-free basis to an immediate annuity. Deferred annuities postpone ordinary income taxation on earnings and gains until withdrawals are made.

To add to investors' confusion, annuities are further broken down on the basis of internal investment characteristics. The choices are limited to fixed, variable, or equity indexed annuities. Fixed and variable annuities can be either deferred or immediate, while equity indexed annuities can only be deferred. Fixed annuities build value at various prevailing interest rates with a stated guaranteed minimum, ensuring that they cannot suffer any principal losses at all. The interest guarantees are typically for a stated number of years, similar to investing in a certificate of deposit at a bank. The term is determined at the time of purchase, with the most common being in the 3-to-7-year range.

In order to offer potential annuity buyers the relative safety of a fixed annuity but with greater return potential, insurance companies created a fixed annuity hybrid known as an equity indexed annuity (EIA). The EIA bases its return on the returns of the U.S. stock market index, typically the broad-based Standard and Poor's (S&P) 500 index. But unlike a variable annuity, the EIA is technically a fixed annuity, offering the guarantee that there will be no losses within the account. However, there is a trade-off. To minimize the insurance company's exposure to possible stock market losses, positive returns are limited by a capped percentage that varies among the different providers.