Annuities: the Answer to a Weak Stock Market?

Annuities, or contracts with insurance companies that usually provide guaranteed income streams, can seem like the holy grail of retirement planning. They offer a safer option for investors worried about the fluctuating stock market or low returns from bonds. But they also tend to be expensive and are sometimes so complicated that even financial advisers have trouble understanding them.

To get to the bottom of this perplexing tool, we spoke with several financial planners about annuities' pros and cons and about why so many people appear to be signing up for them in the wake of the rocky 2008 stock market.

First, the basics: What is an annuity?
There are two primary types of annuities: an immediate annuity, which pays out like a pension, and a deferred annuity, which lets users invest money on a tax-deferred basis. Deferred annuities can be invested in vehicles that pay a fixed amount or in mutual funds that vary with the stock market, or in some combination of the two. Deferred annuities often come with insurance that protects the portfolio against losses as well as benefits that pay out to the holders' beneficiaries in the event of their death, says Michael Reese, president of Centennial Wealth Advisory in Traverse City, Mich.

What's attractive about it?
People tend to be drawn to annuities for safety, since users can protect themselves against losses and guarantee an income stream. During a year like 2008, when the stock market sustains significant losses, people holding annuities tend to fare better. "If you had purchased a safety rider, you may not have lost much of anything," says Reese. "People who owned annuities in 2008 ended up in a much better position" than those who were invested directly in the stock market, he adds.

"The primary function for annuities in today's marketplace is as a risk management tool," says Michael Kitces, director of financial planning at the Columbia, Md.-based Pinnacle Advisory Group. If people want to guarantee a certain minimum income, then they can do that through annuities and invest the rest of their money more aggressively, he says.

What's the downside?
There are two main ones, cost and lack of liquidity. First, the cost: Because annuities often come with insurance or guarantees against losses, the fees tend be higher than for other investment vehicles. Those total costs can be as much as 3 to 4 percent a year, Reese estimates. But he says people who like annuities argue that the expense is justified and that the protection allows users to invest more aggressively in order to generate higher returns to offset those fees.

As for the liquidity of annuities, they often have a period of anywhere from seven to 15 years when users cannot take out more than a certain percentage a year without penalty. Reese says older investors are often concerned that they won't be able to access the funds they need if they have an expensive health problem, for example. But he adds that in certain situations, such as a serious illness or the sudden need for nursing home care, annuities can be accessed without penalty. "If it's 'I want to buy a car or a house,' that's where you get the penalties," says Reese.

Who is a good candidate for an annuity?
People ages 50 and up who want to invest in the market but are willing to pay to protect themselves against losses make good candidates, says Reese. In other words, annuities appeal to people who are risk-averse.

Who's a bad candidate?
Since wealthy clients have enough money to hedge their risk through different investments, they tend not to turn to annuities, says Robert Keebler, partner at Virchow, Krause & Company in Greenbay, Wis.

What happens if the company you buy an annuity from fails?
The law requires insurance companies to set aside reserves for the money they guarantee, which makes them less vulnerable than the banks that have had trouble recently, says Reese. If an insurance company were to go bankrupt, then the state gets involved, either by selling the struggling company to a different one or by calling on the state's own insurance program. "I've been unable to find a situation where anyone has lost a dime on guaranteed amounts," says Reese.