For investors seeking guaranteed retirement income with limited risk, annuity contracts can be good vehicles. Make sure you understand the terms, though.

Burned by the stock market's roller coaster ride and the resulting declines in their 401(k) account balances, retirement savers and investors are giving tax-deferred annuities another look, partly because of the guaranteed returns they offer.

"In the '90s, the equity market basically went straight up," says Russ Kessler, a certified public accountant and partner at the law firm of Kessler & Ballenger Company. "Annuities fell out of favor then, since investors didn't see the guarantees as very valuable. Then the tech and housing bubbles burst, and now investors appreciate the guarantees on the rate of return."

"An annuity guarantees investors a steady stream of income regardless of the economy or stock market. Because annuities are insurance contracts, they can offer these additional guarantees that other investments can't," says Kathy Cunningham, assistant vice president of life marketing for Grange Life Insurance Company.

An annuity is an investment contract-often with an accompanying life insurance component-that provides a series of payments in return for the premium(s) paid. The tax-advantaged products offer a number of immediate and deferred distribution options with either a fixed or variable rate of return. They're most commonly-and appropriately-used to help fund retirement.

Despite their resurgent popularity, not everyone is sold on annuity products. "When we look at annuities, we see an insurance product that's being sold as an investment. We see those as two very different things," says Jim Hamilton, a financial planner at PDS Planning, a fee-based firm.

Hamilton and others wary of annuities contend that all of the bells and whistles in many contracts only confuse investors. They cite high fees-often including stiff upfront sales commissions-and other expenses that can make annuities costlier than other retirement investments.

Do the benefits of a guaranteed rate of return and a lifetime income stream outweigh the risks, costs and limitations of annuities? The pros and cons are many, so careful research is key. Here's what some experts have to say about the role of annuities in today's tumultuous investment environment.

Annuity Basics

Only insurance companies can issue annuity contracts. "Annuities often get lumped in with other financial products, but the issuer must keep the amount of the annuity plus any potential gain in a reserve," says Mary Jo Hudson, director of the Ohio Department of Insurance (ODI). "The fact insurers must have this reserve account makes it significantly different from bank or brokerage products."

The ODI's authority to regulate annuities overlaps authority of the Ohio Department of Commerce to regulate variable annuities-contracts on which the rate of return changes with the performance of underlying investments.

The investor, or annuitant, purchases an annuity by making either a single premium payment or a series of payments. Contract options determine the annuity type, duration, payout schedule and amount and type of retirement income payments. Riders offering additional benefits can be purchased, too.

Annuities have two phases: accumulation and distribution. "Most annuitants earn interest in the accumulation phase. The value increases on a tax-deferred basis," Cunningham says. "In the distribution phase, the annuitant chooses if they want a lump sum, regular distributions for some period of time or guaranteed payments for life through annuitization."

An immediate annuity provides income payments beginning as soon as one month after purchase. Deferred annuities provide payouts according to a schedule specified in the contract.

Fixed annuities increase in value by earning interest, have a guaranteed return and offer stability. Variable annuities don't guarantee fixed earnings, although they may guarantee a minimum rate of return. They're comprised of a number of subaccounts, often based on stock market returns. The annuity's value fluctuates according to the market performance of the underlying investments. Income payments reflect the investment gains or losses of the subaccounts.

Indexed annuities are hybrids of fixed and variable annuities. Tied to the performance of an external stock or bond index, they guarantee a minimum interest rate and offer potentially higher earnings based on the index's performance. The potential gain usually is limited to a percentage of the index's increase or a dollar cap.

Even though life insurance companies sell annuity contracts, they're not traditional life insurance. However, it would be unusual for an annuity not to include death benefits that pay the annuitant's heirs at least the principal amount invested.

"At death, the worst case is that your heirs will get your money back. The better case is that the market will have gone up and so will the annuity's value," says Robert Keidan, founder and president of Keidan Financial Consultants.

Port in the Storm

The simultaneous collapse of the equity and bond markets in late 2008 and early 2009 left many investors seeking stability and fleeing volatility. So it's not surprising that sales of fixed-rate annuities-the safest contracts-rose 39 percent (to $64 billion) in the first six months of 2009, compared with the first half of 2008. Nor is it a shocker that sales of variable annuities fell 26 percent (to $62 billion) in the same six-month comparison. Total individual annuity sales fell 3 percent to $126 billion, according to insurance and financial services consulting firm LIMRA International.

Cunningham says Grange, which sells fixed-rate annuities through independent agents, has experienced a "huge spike" in fixed deferred annuity sales. "People are looking for some certainty," she says. "Annuities are not a sexy product. They're very traditional, very safe and have guarantees. That's usually what people look for in a retirement investment."

Many of Hamilton's clients have "gotten out of the stock market and have cash," he says. "A single-premium fixed annuity that starts paying immediately can make sense for some people. It gives them a base of money during their lifetime. The only bad thing about a fixed annuity is just that: It's fixed. The amount that's distributed can't go down, but it can't go up either to reflect inflation or rising interest rates."

For some investors, the stability that looked so good when the markets were crashing became less appealing when the current market rebound began. In the second quarter of 2009, LIMRA reports, fixed-rate annuity sales dropped 20 percent from the first quarter, while variable annuity sales increased 4 percent and indexed annuity sales jumped 14 percent.

"With the market meltdown in 2008, people turned to fixed-rate annuities out of fear. No one knew how far the market would fall. As the market recovers, fixed-rate annuities are declining and variables are moving ahead," says Eric Henderson, senior vice president of individual investments for Nationwide Financial Services. Nationwide sells fixed- and variable-rate annuities through its in-house agents, independent agents, banks and others.

"From an investment perspective, the most action is occurring in the variable-rate deferred annuity market," Kessler says. "When a client has money to invest, they're looking to a variable annuity product to get a better rate of return."

"Today clients are most interested in variable annuities," agrees Rob Danuloff, a registered representative of LPL Financial, an independent broker-dealer. "They need a growth strategy to recover some of their losses. Indexed or variable annuities offer them potential for greater return, depending on how they invest their subaccounts. And when they move money around in the subaccounts, the transactions aren't taxable."

Insurance companies have grown more aggressive in guaranteeing returns on variable annuities, including guaranteed lifetime withdrawal benefits. "People approaching retirement naturally become more conservative, but a variable annuity allows them to stay invested in equities," Henderson says. "The lifetime withdrawal benefit guarantees them income for life, regardless of how the subaccounts perform or how long they live. If the market performs well, they don't miss out. Their account balance goes up accordingly.

"Annuitization is an exchange of your money for an income stream," Henderson adds. "Many people hate to lose access to their money, though, because once you annuitize, you can't change it. The lifetime withdrawal benefit gives them an income stream and some access to their principal."

Insurers will "guarantee the principal and a certain percent of return," says attorney Faith Williams, chair of Bricker & Eckler's insurance, banking and financial services group and counsel for the Association of Ohio Life Insurance Companies (AOLIC).

Some insurers also limit how much an annuitant can lose. "It's attractive because clients can invest in equity investments with some type of downside protection," Kessler says. "The downside guarantee has saved some clients who had that provision, particularly in recent years with an underperforming stock market."

Taxes & Fees

While annuities offer tax deferral benefits, Henderson says that's no longer the main attraction. "Ten or 15 years ago, tax deferral was incredibly important. It's less so today when compared to the guaranteed lifetime withdrawal benefits," he says.

The tax treatment of annuity distributions can be a negative, particularly for contracts that depend on stock market gains. "Because you're investing after-tax dollars in annuities, it's not deductible for tax purposes," Kessler says. "At distribution, annuities essentially convert a capital gain to ordinary income. Capital gains are taxed at a 15 percent federal tax rate, but ordinary income often is taxed at significantly higher rate."

Cash out an annuity early-before age 59.5-and expect to pay a 10 percent IRS penalty, the same surcharge that's applied to premature distributions from 401(k) retirement accounts.

Annuities can be lucrative, but they're by no means inexpensive. "In variable-rate annuities where clients put money into the underlying subaccounts, the insurance contract fees can be as high as 1.25 to 1.75 percent, and then there are more fees related to the subaccounts," Hamilton says.

Henderson says total fees run about 3 percent for variable annuities. "They do eat into the account balance, but you have the benefit of the guarantees," he says. "And since most annuities are sold through advisors, the fees cover the commission, too."

Variable annuity owners also pay money management fees, and mortality and expense charges to cover the contract's insurance component. Riders for specific contract provisions are an additional expense. Surrender charges apply, too. "They pay a surrender charge to get out of the contract, and it could be high enough to wipe out what they earned in interest," Keidan says.

"Typically the surrender period is seven years. If the contract stays in force, it allows the insurer to recoup the commission paid to the advisor during that time," Henderson says. Annuity contracts generally allow limited annual withdrawals during the surrender period without penalty.

If you buy a mutual fund that tracks a stock index-the S&P 500, for example-you'll earn more than if you buy an annuity that tracks the same index. "If they're tied to the same index and the market goes straight up, mutual funds will beat the annuity in returns because of the higher [annuity] expenses," Kessler says.

Consumer Confusion

Annuitants often misunderstand what is and is not guaranteed. "The guarantee is not for the initial investment amount. It's for the distribution of lifetime income," Hamilton says.

When interest rates are rising, annuity purchasers may find themselves stuck with low returns for protracted periods. Rates on bank certificates of deposit "can go up faster than annuity rates," Keidan says. "With an annuity, they're locking in a lower rate for a longer period of time. If they're purchased in a low interest rate environment, that makes them less attractive compared to other investments whose value increases as the interest rates increase."

Unlike bank certificates of deposit, annuities aren't guaranteed by the Federal Deposit Insurance Corp. "Many types of annuities can lose value in the principal. That's a big difference from a CD," Williams says.

Investors should evaluate annuities as part of their overall financial plan. "Because of all the options, it's not a one-size-fits-all type of product," Danuloff says.

Usually people invest in annuities to supplement their other sources of retirement income-401(k)s, defined benefit plans and Social Security. "It provides additional income, so I think of them as an income vehicle, as well as a way to accumulate retirement funds," Henderson says.

Ohio annuity purchasers have a 20-day "free look" period to review the contract. "If you change your mind, the contract is canceled and you can get your money back," Williams says.

ODI also oversees "suitability rules" to assure annuities aren't sold indiscriminately. "Agents and insurance companies must complete due diligence on the customer and the appropriateness of an annuity," Hudson says. "We used a model from the National Association of Insurance Commissioners and are among 30 or so states that have implemented them. Since we've done that, we've seen a sharp reduction in consumer complaints."

"If there are problems, my experience is that the companies usually reach out to the customer and the annuity seller to find out what happened and solve the issue," Williams says. "If you have an agent selling annuities to those who shouldn't buy it, they'll get into trouble with the regulators and risk litigation. Insurers want to avoid that."

On April 1, Ohio became the second state to begin testing uniform annuity disclosure templates. The one-year initiative is a partnership between ODI, the American Council of Life Insurers and AOLIC. It's intended to provide annuity investors with clear, concise information.

"Insurance companies use different formats to describe their annuity products. The templates we're testing have a standard format, so consumers can more easily compare key information," Hudson says.

If the pilot is successful, ODI could move toward adopting rules requiring all Ohio-licensed insurers that sell annuities to use the uniform disclosures.

Lisa Hooker is a freelance writer.

Reprinted from the March 2010 issue of Columbus C.E.O. Copyright © Columbus C.E.O.