Making Sense of Annuities

To help you understand annuities, a little crash course may help. Annuities are a type of investment that's issued by insurance companies and sold by insurance agents, brokers, financial planners and even some companies on the Web.

Basically, there are three types of annuities.

Immediate Annuities

You hand over a sum of money to an insurance company, say $100,000, in return for the insurer's promise to pay you an income over a specified period of time, say, for the rest of your life. The payment you receive is based on your life expectancy, as estimated by the insurance company.

You have two options. With a fixed immediate annuity, the payment is, well, fixed -- say, $800 or so a month for life if you're a 65-year-old man investing $100,000.

With a variable immediate annuity, the amount could vary based on the investments in the annuity. If the annuity is invested primarily in stocks, the income stream could be volatile in the short term, but the idea is that it should grow over time.

If you die a few months after buying an immediate life annuity, the insurance company wins big time because it gets to keep your money and no longer has to make the payments unless you set up your annuity to pay to your beneficiaries.

There are plenty of other income-annuity variations: You can select a shorter time frame, for example, or name beneficiaries who would continue receiving payments after your death. The trade-off would be receiving small income payments while you're alive.

There is one other thing to consider. Unless you get a cost-of-living increase, inflation will erode the purchasing power of your monthly payment. That won't be a problem if you've got enough stashed away in CDs or other investments to take care of any shortfall. But if you think your pension plus your CD money might not cover your expenses adequately 10, 20 or (thinking positively) 30 years from now, then you could consider putting some of your money into a variable annuity invested at least partly in stock accounts so the payment it generates has a good chance of growing over time.

Deferred Variable Annuities

With this breed, you get to invest in a variety of "subaccounts," portfolios that function like mutual funds.

The advantage is that money in subaccounts grows tax-free until you take out the money. And you can move money between subaccounts with no tax consequences.

On the negative side, subaccounts in a deferred variable annuity tend to have higher operating expenses than mutual funds, which puts a drag on their returns. There are also "surrender fees," another set of fees that kicks in if you move your money out of a deferred variable annuity within a certain number of years, usually five to 10 years.

And while deferring taxes on gains is certainly a plus, you get hit upon withdrawal, paying income tax rates that run up to 39.1 % this year. Capital gains in a regular mutual fund would be a lot less.

The bottom line is that it can take many, many years -- 15, 20, or even more -- for the advantages of tax-deferred growth to outweigh the drag of high fees and the disadvantage of ordinary income tax rates at withdrawal. You probably shouldn't plan to invest in a deferred variable annuity unless you plan to keep your money there at least 15 years.

Fixed Annuities

Which brings us to the third option. A fixed annuity works much like a certificate of deposit. You invest your money and are paid a given rate of interest for a specified term. For example, an insurer might promise to pay 3 % for a one year, 5 % for five years or 6 % for 10 years.

Unlike interest paid on a CD, however, a fixed annuity's interest payments are not taxed as long as you keep the money within the annuity. So, as with a deferred variable annuity, you get the advantage of tax deferral.

But fixed annuities also have their downsides. There are surrender fees for early withdrawal. And you have to watch out for gimmicks: Some offer bonus rates that you get only if you remain in the annuity for a long time, for example. And you've also got to be careful about how long you actually get the quoted rate. A 10-year annuity may only guarantee its quoted rate for one year. If it changes after that, you could be stuck (unless you want to pay the surrender fees).

So is the tax-deferral advantage worth all that trouble? By postponing tax on interest, you money works for you for a little longer. But unless you're investing big bucks, deferring taxes for just a year or two doesn't amount to much. And if you have to pay a surrender charge to get at your money, any advantage from tax deferral can easily be wiped out. So, plan to keep your money in a fixed annuity for a long time.