Annuities fundamentally are a guaranteed income stream paid over some period of time that can be as long as the owners lifetime. The Federal Government provides the best known form of annuity through Social Security, but the term “annuity” is reserved for contracts that are issued by an insurance company.

Annuities are the financial services product that people love to hate. The financial advisers that worked with me in the firm that I managed could hardly contain their eye rolls at the mention of the word annuity. Survey after survey indicates that while retirement plan participants want the benefits of guaranteed income and shelter from the risks of the equity market that annuities provide, if the solution has annuity in the name, their interest falls to nearly zero. Insurance agents are paid a commission to sell annuities, so some financial advisers are concerned the agent won’t have the client’s best interest at heart. In addition the products come with some restrictions that are worrisome on the surface but allow the products to provide their core benefits.

I have been surprised to find how few people are even familiar with annuities. There are three forms of annuity contracts available through the insurance market with several variations in each form.

Income annuities are contracts that pay a fixed amount monthly for a defined period, the investors lifetime or the lifetime of the investor and his or her spouse. The product is designed to pay out all of the principal and interest earned over the time period chosen, and therefore the product cannot be cashed in. If a lifetime annuity is purchased, there is no cash value for family members or other heirs regardless of how long the annuity was held. When told their money will be tied up in this way, many people balk. However there are no other products that can provide a guaranteed income for life, and most contracts allow you to select a minimum payment term (called a period certain) and payments that will last through both spouses lifetimes (called joint and survivor) to make sure you get the most from your investment. In today’s market you can buy an income annuity that pays out between $400 and $500 per month per $100,000 depending on your age, the insurer and the time period selected.

Deferred annuities are contracts that earn a guaranteed interest rate over a fixed time period, such as five, seven or ten years. At the end of the period, you can continue to receive interest at the new going rate, cash out the annuity in whole, transfer the balance to a different annuity or convert the annuity into guaranteed monthly payments. These contracts are good for accumulating income before you need to be paid a monthly income stream. The income grows tax free until it is withdrawn. While you can cash out your annuity early, there are penalties, called surrender charges and/or market value adjustments, if you do. These penalties generally decline over the life of the contract, but can be significant early on. The penalties are designed to protect the insurance company from losses in the event they have to sell the investments that support the contract. They allow the insurance company to invest in higher interest paying investments that line up with the term of the annuity contract and therefore offer rates that are generally higher than what can be found in similar investment products, such as bank certificates of deposits (CDs). Annual interest rates for simple five year deferred annuities currently range between 1.50% and 2.00% on the Fidelity Investments web site. The current average 5 year CD annual interest rate as reported by Bankrate.com is 0.86%.

Variable annuities are the most complex of the annuity product categories. With a variable annuity, the return that you receive on an annual basis is generally not guaranteed but rather dependent on the investments you choose within the product. Variable annuities allow you to choose from a variety of mutual funds across several categories of stocks, bonds and money market funds. They usually will also offer a fixed account, where the interest rate may vary subject to a guaranteed minimum rate. Your investment will grow according to the performance of the funds you choose, and it may decline in value. The contract does provide a death benefit for your beneficiary, usually at least equal to the value of your total deposits, regardless of the performance of the funds you choose. Like deferred annuities, you can cash out the value of your annuity after the surrender charge period, remain in the annuity, transfer your balance to another annuity or convert the balance to a monthly income stream. Income and capital gains accumulate tax free until withdrawn from the contract.

Many years ago, when I was a newly minted investment professional, my mother received life insurance proceeds following my stepfather’s death. It wasn’t a large sum in the scheme of things, but it was more money than Mom had seen in one place in her life. Mom asked me to put it in an annuity for her. She was looking for an income annuity, but I talked her out of it. Mom wasn’t that old at the time, and if the money were invested wisely in a combination of stock and bond mutual funds, I expected she would get a better return. While I was correct that there were better returning investment options for my Mom, I was absolutely wrong to not have helped her purchase an annuity. Mom couldn’t take the sight of the value of her investments going up and down. She cashed in the investments I recommended and used the money for something she understood better – improving her house. Had she had an annuity instead, she would have had a small monthly income that she could have really used to supplement her social security check.

When choosing an investment, the return is rarely the most important part of the decision. The minimum that has to be considered is for what will the money be used. Most people need some assurance of a monthly income after they stop earning a paycheck, and the only way to guarantee that is with an annuity. Even if you don’t need a monthly income stream now, saving in a vehicle that can be converted to one in the future is worthwhile for at least a portion of your investments. You may see such an opportunity coming to your own retirement plan in the near future. The retirement, insurance and investment industries are developing products that work within a retirement plan framework. If one becomes available to you, take a close look.