In the wake of the recent financial meltdown, the income guarantees offered by annuities have become quite attractive.

Deferred fixed annuities, for example, pay sizable rates of 4% to 5% for a specific term. Meanwhile, fixed immediate annuities guarantee policyholders lifetime income based on payout rates of 6% to 9%, depending upon the insurance company and the age of the policyholder.

And variable annuities, which let clients choose from an array of investments, typically pay out at least 4% to 5% of the benefit base annually for life in the form of guaranteed lifetime withdrawal benefits. Plus, at the policyholder's death, variable annuities guarantee to the policyholder's beneficiary the principal or market value, whichever is greater.

Given these types of fat payout rates vis-à-vis the near-zero percent yields currently dished out by many government securities, money market funds and CDs, it's not surprising that more investors--especially those looking for guaranteed income benefits--are taking a shine to annuities. According to a recent survey of 4,000 affluent investors conducted by Cogent Research, the allocation of assets to annuities jumped 10% from 2006 through 2009.
"Ownership of annuities, including fixed and variable, is on the rise across all age and wealth segments, particularly among cautious, affluent investors," says Meredith Lloyd Rice, senior project director at Cambridge, Mass.-based Cogent.

That said, sales of all types of annuities declined 11% in 2009, according to LIMRA, an association of insurance and financial services companies in Windsor, Conn. The reason: Low interest rates on fixed immediate and deferred annuities, as well as economic and stock market concerns.    

Annuities are contracts sold by insurance companies that guarantee investors either fixed or variable payments that can kick in immediately or at a later date. These investment vehicles come in many different flavors, and often entail hefty insurance fees and/or surrender charges. 

Equity Index Annuities
Purchases of equity index annuities last year were the exception to the industrywide sales slump. Equity index annuities, which typically pay a variable rate based on the performance of an index, saw sales hit $29 billion in 2009. That's a 9% increase over the prior year, according to LIMRA.    

Equity index annuities often contain an interest rate floor of roughly 2% to 3%, attracting safety-minded investors. But like annuities in general, these vehicles are complicated beasts that have various potential drawbacks. For starters, the participation rate--which is the percentage of an index's rise that the insurance company allocates to an annuity--can vary. So if the participation rate is 60% of the performance of an index, that means investors wouldn't capture the full upside of that index in a bull market.

There might also be an interest rate "cap" that limits how high a client's interest rate can go. Or there may be a "margin," "spread" or "administrative fee" subtracted from the index.

Sometimes, the participation rate percentages, caps or margins can change during the contract term. And not all contracts guarantee a client's full principal. Some may only guarantee 90% of principal in exchange for, say, a higher percentage gain on the upside.

The annuity return also excludes the reinvestment of dividends. And like other annuity products, an equity index annuity has back-end surrender charges.

But during the five-year period through year-end 2009, the average equity index annuity outperformed both the S&P 500 and one- and five-year CDs, according to Advantage Compendium, a St. Louis-based annuities research company. Indeed, in that timeframe the average equity index annuity grew at a 4.2% annual rate versus zilch for the S&P 500.

"The main reason sales of equity index annuities are up is due to falling CD rates and safety concerns," says Jack Marrion, president of Advantage Compendium. "It [an equity index annuity] is a safe money place with the potential for more interest."

An investment in an equity-index annuity is tax-deferred. At maturity, the policyholder can cash out and pay income taxes on earnings, or opt to receive periodic payments for life. But withdrawals from any type of tax-deferred annuity before age 59½ can result in a 10% IRS fine.

One of the more innovative types of annuity products is a fixed hybrid annuity that can be used to pay for long-term care. In 2009, sales of fixed hybrid annuities were more than $600 million, according to Milliman, a consulting and actuarial firm in Seattle. Policies issued by Genworth, John Hancock and United Omaha Life Insurance Co. pay out two to three times the account value for long-term care for up to six years. For example, a client who invested $100,000 in a fixed hybrid annuity that grew to $150,000 by the time a long-term care claim is filed might get $300,000 to $450,000 of long-term care coverage, Milliman says.

Anthony Domino, a Rye Brook, N.Y.-based financial planner, says annuities with long-term care provisions may provide a lower-cost option for some clients. "The tradeoff with combination products is that you give up the annuity earnings if you use it for long-term care," he says.

Variable Annuities
Sales of tax-deferred variable annuities, in which the policyholder does the investing, dropped 18% in 2009 due to the dismal stock market performance the prior year, as well as high fees.

Nonetheless, some financial advisors recommend that clients put annuities in IRAs or IRA rollover accounts, according to a survey by the Insured Retirement Institute in Washington, D.C. Seventy percent of the advisors polled cited variable annuity death benefit guarantees and guaranteed lifetime withdrawal benefits as reasons.

In that vein, more than 85% of variable annuity policyholders have been electing guaranteed lifetime withdrawal benefits, according to LIMRA. These benefits typically guarantee policyholders income of at least 4% to 5% of their benefit base annually when they retire, regardless of how the underlying investment performs.

The most sought-after variable annuity, LIMRA reports, has been a Prudential product called Highest Daily Lifetime 6 Plus, which lets investors lock in the highest daily value of the annuity contract for income purposes. This variable annuity comes with a 6% guaranteed lifetime withdrawal benefit, along with a spousal option. However, annual charges can reach as much as 300 basis points.

New generation products recently issued by Hartford Life and AXA Equitable have dual accounts that provide folks with an accumulation account with no underlying income guarantee and an option with a lifetime future income guarantee. The products are designed to act like a personal defined benefit pension.

On the no-load side,  Ameritas Life Insurance Co. offers a low-cost surrender, fee-free variable annuity with a guaranteed lifetime withdrawal benefit. And sources ndicate that Vanguard is considering adding the benefit to its no-load product.

Immediate Annuities
With immediate annuities, which are irrevocable, policyholders invest a lump sum in return for insurance company-guaranteed income--generally monthly--for as long as they live. Only about 40% of the income is taxable. The rest is considered a return of principal, according to the IRS.
Based on data from the Comparative Annuity Reports Web site, a 70-year-old male today with $100,000 in a fixed immediate annuity would collect an average of about $8,532 in annual income for as long as he lives.

The drawback: With immediate annuities, clients may be surrendering their assets to insurance companies. And while contract provisions can be made for beneficiaries to continue to receive income for a specific period, expect a policyholder to receive a lower payout under this arrangement. New products also let policyholders withdraw cash, but monthly payments are lower.   

Although immediate annuities are an illiquid investment, research from the likes of Conning Research in Hartford and Moshe Milevsky, a finance professor at York University in Toronto, show that these products can stabilize a retiree's income and improve the return per unit of risk to a portfolio of stocks, bonds and cash. In addition, Monte Carlo simulations show there is a greater chance a retiree's portfolio won't run out of money during his or her lifetime.