In the increasingly complex world of financial instruments, annuities have taken their licks lately as the outdated and costly way to guarantee an income stream during retirement. For boomers who fell in love with mutual funds during the go-go bull market of the ’90s, annuities have all the appeal of grandpa’s old station wagon.

But don’t be too quick to cast all annuities aside. Although attempts by insurers to add sexy new features have only muddled an already-confusing product, some annuities may yet find a place in your retirement planning, particularly if you’ve maxed out your IRA and 401(k).

What’s new with creaky old annuities? How can they benefit you and your family? Let’s cut through the clutter and take a closer look.

Annuities 101

In concept, annuities are one of the insurance industry’s simplest products: You give the insurance company X amount, either in a lump sum or in premiums over time, and they annuitize it into periodic payments for either a fixed period, the rest of your life or extending on to the life of your spouse or beneficiary, depending on the policy.

If you buy a fixed annuity, you know the exact amount you will receive when your payoffs begin. If you buy a variable annuity, you invest in a menu of subaccounts much like mutual funds, and your payouts will depend on the performance of the underlying stocks, bonds and money market funds. Think of variable annuities as mutual funds in a life-insurance wrapper.

A deferred annuity, either fixed or variable, involves an accumulation period during which you pay premiums before payments begin. An immediate annuity triggers payouts when you buy or transfer funds into it.

Your grandparents prized annuities for their tax-deferred status; Uncle Sam doesn’t get a cent of your investment or earnings until the payouts begin. In the days before tax-deferred IRAs and 401(k) plans became commonplace, annuities were one of the few tax havens readily available to the working class.

According to the American Council of Life Insurers, payments into annuities during 2003 totaled $289 billion. Individual annuity owners, as opposed to participants in group annuity plans, received $31 billion in benefit payments, leaving $1.2 trillion in individual annuity reserves at year’s end.

The trouble with annuities

The trouble with annuities in today’s economic environment starts with the term “annuities” itself.

“You must make the distinction between fixed annuities, which are arguably attractive to those who otherwise would have money in bank CDs, and variable annuities, whose costs are extraordinarily high,” says Jim Hunt, a Concord, N.H.-based life insurance actuary affiliated with the Consumer Federation of America. “In the popular press, the general tenor of remarks is that all annuities are bad. It’s hard to say that fixed annuities marketed by banks alongside their CDs are bad when the interest rate may be as high or higher and there’s a tax deferral.”

What further muddies the annuities discussion is the apples-to-bananas comparison of annuities to no-load mutual funds as an investment vehicle. In this mismatch, variable annuities take a beating on:

  • Cost: That insurance wrapper comes with an additional layer of fees for mortality and expense risk that push the average domestic-stock variable annuity cost to 2.21 percent of the value of the investment, according to Morningstar.com. That’s double the average fee for no-load mutual funds. Hunt estimates that it would take at least 20 years for variable annuity returns to recoup the differential in fees.
  • Lock: Annuities lock your money up for anywhere from six to 10 years during the accumulation period. If you withdraw money before the period is up, you’ll likely pay a surrender fee of anywhere from 7 percent to 20 percent to your insurer. If you touch your funds before age 59½, you’ll also pay a 10-percent penalty to the federal government.
  • Limits: Most variable annuities offer a limited range of investment options. Fees may apply if you choose more than the allotted number of subaccounts.
  • Taxes: Earnings withdrawn from an annuity are taxed as ordinary income, rather than at the more-favorable capital gains rate.

The fallacy in this comparison, of course, is that variable annuities were never designed to beat the street. They are first and foremost an insurance product aimed primarily at preretirees who can’t stomach market risk and would otherwise invest in CDs (and hope that inflation doesn’t eat up their earnings).

Kitchen-table thievery

Barry Katz, a fee-only financial planner with Caratel Financial Services in Sunrise, Fla., says overzealous insurance agents lured by the lucrative commissions on variable annuities (upwards of 10 percent) have made a bad deal even worse for some older Americans.

“Unqualified insurance people have sold annuities as places to put your IRA, which is simply an out-and-out wrong thing to do. IRAs are tax-deferred. Why put a tax-deferred vehicle into an annuity which is tax-deferred, other than to pay somebody’s commission? It’s not that the product itself is a bad thing in all cases; I just think it’s been oversold. It’s been abused,” he says.

Insurance companies have added a blinding array of new features to the variable annuity in recent years to offset the one-two punch of the capital-gains tax cut (to 15 percent) and the market decline which have caused variable annuity sales to drop off from their 2000 peak of $307 billion. Some policies now guarantee that, after the accumulation period, investors will at least retain the amount invested. Others will credit your variable annuity with the highest value it reached over a 10-year period. Still others guarantee an annual rate of return. Companies have similarly expanded their “step-ups,” enhancements, to allow investors to withdraw earnings with a reduced penalty. But few of these frills come free.

Katz can’t bring himself to recommend annuities.

“I believe in insurance, insurance is a great product, but insurance is there to cover a specific financial risk. As an investment, insurance typically stinks,” he says. “I’m a firm believer in no-load mutual funds. You can build a properly diversified portfolio of low-risk mutual fund investments and achieve a return greater than that on an annuity given the same level of investment risk.”

Hunt agrees that annuities fall short as an investment option. If pressed, he recommends the low-fee, equity-indexed products offered by Vanguard and TIAA-CREF, or Teachers Insurance and Annuities Association-College Retirement Equities Fund, which introduced variable annuities back in 1952.

“When the tax laws were changed to make the minimum tax rate on qualified dividends and long-term capital gains 15 percent, I think it became very hard to justify variable annuities unless you were doing something like junk bonds or maybe real estate,” he says.

Even the Securities and Exchange Commission agrees: “For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity.”

Die broke gracefully

Stephen Pollan, the financial adviser whose “Die Broke” manifesto shook up traditional retirement thinking, included annuities as part of his revolutionary four-part program: Quit today. Pay cash. Don’t retire. Die broke. The idea is: You can’t take it with you, and you’ll only cause dissension and sloth among your survivors by passing it on, so why bother?

“I still am very bullish about annuities if you strip them of their bells and whistles,” Pollan says. “Some of the charitable annuities, even with the (meager) interest rates, when you take the charitable deduction, they’re still not bad.”

Much of Pollan’s philosophy involves shifting your financial risk to insurers. In his case, he learned how to maximize his earnings by buying a fixed annuity without specifying the length of the payout period, designated in annuities by the word “certain.”

“When I bought my first annuity, say it was $100,000 — $10,000 a year, I said, ‘Let’s make it 10-years certain and then it’s over at my death.’ Now I did that because I thought I was getting a large part of my money back and I was getting a better deal. But it was untrue because if I had eliminated the 10-years certain, I would have gotten a much-higher yield. I should have more confidence in longevity, because that’s what you’re buying; you’re buying insurance in favor of longevity. So you should be willing to give it up; don’t ask for certain. Play the game, and playing the game is, you want to beat them by living as long as you can.”

Pollan says if you’re committed to spending it all (“Your last check should be to the undertaker, and it should bounce,” he says), annuities are still a great way to do it.

“Most people don’t like to spend down. Figuring out your date of death is practically impossible. But if you buy an annuity, you spend down safely. The checks are going to keep coming, and on the day of your death, you’re not going to be opening your mail anyway.”