When my clients Sharon and Lisa called to ask about annuities, I took a deep breath. “This is not simple,” I said, “but that doesn’t mean it’s bad! But we have to make sure it fits into your plan. Con-sidering all your options is always the best way to go. Be very careful before you invest funds in an annuity. Make sure you understand what you are buying and are comfortable with it.”

Simply, an annuity is an investment made now to accumulate and pay out later in a stream of payments within an insurance wrapper (providing death benefits and other options). The goal is to supplement retirement income.

For this discussion, I am referring to annuities outside retirement plans, such as IRAs or 401Ks (i.e., nonqualified annuities). The funds used for nonqualified annuities are after-tax dollars.

Because annuities are a form of insurance, they are regulated by state departments of insurance. Generally an insurance agent earns commissions on sales.

The major benefits of an annuity:

• Taxes are deferred on any earnings until funds are withdrawn after age 591⁄2 (with a few other exceptions).

• Annuity payments could last for the rest of your life, depending on the payout schedule selected.

• Nonqualified annuities can supplement retirement if you have maxed out your retirement contributions.

• Certain guarantees are available — but every guarantee has a cost, and the provisions of the guarantees can be extremely complicated.

The major drawbacks:

• Annuity products can be complicated and lock up your funds for years.

• The costs in commissions, ongoing fees, surrender charges and taxes due might be much higher than nonannuity investment alternatives.

• The financial strength of the insurance company sponsoring the annuity, is vital, because state guarantees might not be sufficient to cover losses.

• Should the owner die, an annuity may not be beneficial for the spouse from an estate-planning point of view.

Annuities also are classified by investment type — variable or fixed — and type of payout. Variable generally means mutual funds investing in stocks, bonds, fixed income, real estate and other securities that have no guarantee. A fixed-rate annuity generally offers a less risky fixed-rate return that varies for each contract. Often a teaser rate is offered for the first year, and then a floor of some guaranteed rate is offered. The credited rate each year can be higher, but for planning purposes one should assume it drops to the minimum.

Type of payout means how you choose to receive income. The most important distinction is between deferred payout, meaning the funds are invested for a period of time before paying out, and immediate annuity, which is annuitized the month following deposit of your funds to resemble a pension payout.

These are not simple solutions, but it doesn’t mean that annuities aren’t the way to go. What’s needed is careful, thoughtful and diligent consideration of all options based on your needs. For instance, with the disappearance of the defined benefit retirement plan or pension, annuities can serve the same function of providing lifetime payments.

Variable annuities tend to have higher expenses because your investment choices are mutual funds (with fund management fees). Coupled with annuity expenses, that could result in fees as high as 3 percent. I have discussed the impact of high fees on your investment returns in previous columns.

Look at the expenses of the underlying funds, and when available choose passive index funds (rather than actively managed funds). Also look at the fees imposed by the insurance company, including commissions and mortality and policy expense costs.

Most important, never put all of your investment funds in an annuity or even many annuities.

When I recommend considering an annuity, I use no-load insurance companies where there are no imposed commissions or surrender charges.

If you are considering an annuity, I recommend you consult a fee-only financial planner who can help you understand the annuity and help you determine whether it fits into your total financial plan.

Ira Fateman is a certified financial planner at SAS in San Francisco who conducts free personal finance workshops for Hebrew Free Loan (www.hflasf.org/financialfitness). Reach him at [email protected]