Here are the basics of annuities.

TYPES In its most basic form, an annuity is a contract with an insurance company that makes payments at regular intervals for a set period of time. The classic fixed-annuity provided people a set payment for however long they lived — from a few months to decades. An insurance company’s actuaries took their best guess on your life expectancy while you hoped to outwit them and collect a check into your 90s.

Few annuities are structured this way anymore. One reason is people have realized that a static payout is not great. For one thing, it does not account for inflation: $1,000 a month today will probably not buy as much in 10 or 20 years.

To make annuities more appealing — and to bring in more money — insurance companies created more sophisticated types of variable annuities.

Many of these annuities offer the option of a higher payment if the value of the underlying securities rises yet lock in a minimum payment if they fall.

One popular annuity gives people a sense of flexibility by allowing them to withdraw some or, in certain cases, all the principal, if they need it. In living longer, people will require income for more time but they are also increasing their chances of contracting catastrophic illnesses, from cancer to Alzheimer’s, that carry huge medical costs. The guarantee of regular payments is comforting. But the need for a lump sum at a particular time can sometimes be more practical.

Other popular models are structured to continue after the original beneficiary’s death. A “joint-survivor” clause stipulates that if the husband dies first, the annuity continues to pay out to his wife through her lifetime, while another provision leaves some of the remaining principal to other heirs.

IMMEDIATE VERSUS DEFERRED These are two terms that are often used when discussing annuities. The difference is simple but often obscures the vast array of annuities being offered. With an immediate annuity, a person pays a lump sum and begins receiving income right away. That’s the immediate part. In the past, these were usually life-only annuities, meaning if you died a week later, that money was gone. Now, immediate annuities have all the variations mentioned above.

A deferred annuity has two phases — accumulation and distribution. Over a period of time, a person builds up the value of the annuity and then selects a time to start receiving payments from it. People who change jobs, for example, could opt to roll their Individual Retirement Accounts into an annuity and let the money grow there. Or they could make contributions to the annuity for a set period of time as they would with any savings plan. When they have accumulated enough to finance their goals, they can decide when they want to start receiving payments. They can start and stop the payments at will, though the idea is that they will wait until retirement.

ALLOCATION TO ANNUITIES Regardless of what type of annuity you select, the main question is how much of your portfolio should you put into one? The rule of thumb is to use annuities to cover your basic living expenses. Most providers recommend that you put no more than a third of your assets in annuities. Others limit retirees to 75 percent. Financial advisers not associated with insurance companies will generally argue for putting little in annuities: they feel they can get better returns through a diversified portfolio of securities. That’s a harder sell, though, after two rounds of huge losses in the stock market in one decade.

BENEFITS AND LIMITATIONS The benefit of putting a chunk of your nest egg into annuities is the guaranteed payment. Whether the economy is good or bad, an annuity pays a minimum amount of income every month. You may have to put a large part of your nest egg into the annuity to receive the amount you need to live on, but you know it will be there.

There are four main downsides to annuities. First, they are expensive. A fixed annuity typically pays out no more than 5 percent of the principal each year. That means you would have to put $100,000 into a fixed annuity to receive an annual payout of $5,000. Even the most frugal retirees would struggle to live on $400 a month. To receive, say, $2,000 a month, they would have to invest $500,000.

The other cost is the fees associated with the annuities. One rule of thumb is the more guaranteed features attached to an annuity — from inflation adjustment to joint survivor — the higher the cost. These costs, as with mutual funds, are embedded in the annuity itself. They do not come in an upfront fee but are hidden in the payouts.

A third problem is expectations. People who bought annuities with payments that grew as the underlying securities grew could be in trouble. Those payouts are not going up when the stock market loses 40 percent of its value in one year. Likewise, when government policy makers are more worried about deflation than inflation, payments that adjust for the cost of living are going to remain at the guaranteed minimum.

Lastly, the government taxes distributions from annuities as ordinary income, with rates that run up to 35 percent. Money put into a brokerage account is taxed at the capital gains rate, currently 15 percent. Under the current tax regime, if someone receives a payout greater than $32,500 a year, that would be taxed at a 25 percent income tax rate — higher than if that same amount had been paid out through a brokerage account.

The popularity of annuities waxes and wanes with the economic cycle. They had a resurgence in the years after the technology bubble burst in 2001 and 2002. The recession of 2008 could do the same, though insurance companies may be constrained: in response to previous demand, they underwrote so many annuities that credit rating agencies are questioning their risk management skills.

Like any part of a portfolio, annuities are best taken in moderation. They are a great way to guarantee a certain amount of fixed income in retirement. But if overdone, they could rob a portfolio of needed flexibility.

For more on annuities, the Securities and Exchange Commission offers some basic information on one part of its Web site and more specific guidance on variable annuities as well. The Insurance Information Institute’s annuity guidance is also useful. The Hartford, one of the leading sellers of annuities, offers a fair bit of good information here, and MetLife, another leading purveyor, presents its own guide to deferred and immediate annuities as well.

Article source: http://www.nytimes.com/2009/01/28/your-money/annuities/primerannuities.html?partner=rss&emc=rss