Fixed annuities can be a good fit for some retirees. A constant stream of cash that lasts as long as the annuitant lives can be appealing for those who suspect they'll live a long time and also want no exposure to risk for at least part of their retirement portfolio.
"It's very much like if you were leaving a company and you had a pension with an option to roll it over or get a stream of income," says McClain.
Variable-rate annuities, on the other hand, are invested in securities that can possibly lose value. Recent innovations in variable annuity offerings have mitigated some of the potential volatility.
"I'd never used annuities, but when they came out with the 'living benefits' with income and guarantee against market loss, that changed the whole picture," says Certified Financial Planner Bill Garrett, president of Garrett Financial.
On a very basic level, living benefits guarantee to pay back at least the original amount that was invested, no matter how poorly the portfolio of investments performs. A guarantee against market loss sets a floor on the returns annuitants receive.
When investing $100,000, for instance, the distribution amount will always be based on the initial investment, even if the market value of the portfolio slips to $90,000. If, however, the value increases, the floor moves up and you get a new high water mark. If you were receiving 4 percent annually, you will continue to get $4,000 every year even if the total value of the portfolio drops. If it goes up to $150,000, your new payment would be $6,000.
Sounds great, right? But fees and taxes complicate the issue for immediate annuities, not to mention the fact that they can be fairly convoluted products in general. Anyone interested in annuities should do their homework, research them thoroughly and compare offers.
"It's like anything with too much security -- there are unintended consequences," says Certified Financial Planner Joseph Birkofer, principal at Legacy Asset Management in Houston. "I have some clients with vast amounts of money tied up in variable annuities -- every time they take out $1 it costs them 30 cents."
"It comes at a cost," agrees Parks. "You pay the company a significant amount so that the money will not run out within your lifetime."
While the initial investment amount is considered a return of capital and will not be subject to taxes, any earnings gains are. If you use money from a qualified plan that gets favorable tax treatment, such as a 401(k), to purchase the annuity, then the entire investment is subject to taxes.
"They are taxed as ordinary income versus capital gains," says Birkofer.