Say you invest $100,000 in a variable annuity. Over the next few years, the value of the mutual funds held in your variable annuity declines to $75,000. A declining investment in a straight mutual fund would mean your heirs would get only $75,000. With an annuity, your beneficiaries still would get the $100,000 if you die. And, with some death benefit arrangements, if the market value of the annuity has risen to $125,000, your beneficiaries would receive that amount.

The tax situation is the same as for fixed-rate annuities; earnings are taxed as ordinary income no matter how long they're held. You never want to use annuities in a qualified retirement account such as a 401(k) or an IRA. Those plans allow you to accumulate money on a tax-deferred basis. There's no sense in paying the higher costs of an annuity when you can simply invest in a mutual fund and reap the benefits of deferring taxes less expensively.

Variables make good sense if you've already reached the limit on your other retirement savings vehicles, yet still have money you'd like to squirrel away and can part with long term. You're not limited in the amount you can invest in an annuity, as you are with IRAs and some other retirement-savings vehicles.

Variable annuities offer some other features that can make them appealing to certain investors, despite the drawbacks. Most significantly, many allow you, for a fee, to convert your investment to an annual income stream or annuitize it. The insurance company guarantees that you will receive income payments, either for a certain period of time or for as long as you live.

CD-type annuities

These are fixed-rate annuities, but the guaranteed rate matches the penalty period. In other words, if you buy a five-year CD-type annuity at 4 percent, you're guaranteed to get 4 percent annually if you hold the CD for five years. One problem with this is that, if rates rise, you're locked in at a lower rate.

The CD-type annuity was developed to solve the problem of insurers making empty promises to continue paying a high interest rate after the guaranteed period. Rates were falling and customers weren't getting what they expected, so they paid a penalty to get out of the investment.

Typically, CD-type annuities offer a higher interest rate than nonannuity CDs. They are a tax-deferred investment, but if you cash your five-year CD before age 59½, you'll pay the IRS a 10-percent penalty on the gain. However, many contracts allow customers to take out up to 10 percent of the balance or up to 100 percent of the interest annually without insurance company penalties.

Surrender charges on a CD-type annuity are similar to a typical fixed-rate annuity, and there is no FDIC coverage on these investments. Some CD-type annuities have an escape hatch. The insurance company penalty will be waived if the customer allows the insurance company to pay them over a five-year period or longer.