Suppose that when it comes to retirement planning, you do everything right. You estimate how many years you will have to draw down your assets, rather than accumulating wealth through full-time work; you figure out how much money you will need per year; and you build your portfolio toward the required total. The unfortunate truth is that even then, you ll still face two major financial risks as you grow older. One is inflation: Your money will buy less in the future than it does today, and it may buy less than you expect, particularly if medical costs remain out of control. That s why it s so important to stay invested in equities.

The other risk is longevity. If you re 65 now, Census Bureau data says you can expect to live another 18.7 years, but that hardly means it s safe to plan a 19-year retirement. For one thing, that statistic is an average, which means about half of 65-year-old Americans will live longer. For another, life expectancies are growing all the time. That s great news unless you outlive your assets.
That s where annuities come into the picture. An annuity is any stream of specific payments over a specific amount of time. It s not hard to understand how the idea of guaranteed income has particular appeal these days, and the financial-services industry is ready with a slew of products that come with an endless number of extra features.

The simplest form of an annuity as an investing vehicle is called an immediate life annuity, for which you pay a financial-services company a sum of money, and it guarantees regular payments back to you for the rest of your life. If, say, Patricia is a 70-year-old woman who purchases an immediate annuity for $100,000, she could expect about $700 every month for the rest of her life.
The value of anything whose worth can be parceled out whether it s a rosebush or a million-dollar pile of cash can be expressed as a lump sum or an annuity. But the firms that sell annuities (usually insurance companies) also pool, and therefore cut, the same longevity risk from which you re trying to protect yourself. After all, some of the people who buy annuities die before they expect to, and annuity firms use their money to offer attractive payouts to survivors (and make a profit). In Patricia s case, she ll get 8.4 percent of her initial investment ($8,400) every year.

That 8.4 percent figure isn t equivalent to the yield on a bond or interest on a savings account though you will frequently see them held up as comparisons because with an annuity, your investment is devoured by your payouts and not available to you for liquidation. The good news about that is, because an annuity returns your principal to you over time, the part of your payout attributable to your initial investment is tax-exempt. (The precise portion you can exclude from your taxable income is determined by Internal Revenue Service actuarial tables and is a calculation your annuity company or financial planner can perform.) The bad news for your heirs is that every dollar you put into an annuity is one dollar less you can pass on to them.

Because the math behind immediate annuities is relatively straightforward, the firms that sell them don t have a lot of wiggle room in their marketing so it s easy to read their price tags. Just go to www.immediateannuities.com and enter your age, gender and home state; you can find out how much an initial purchase will return or how much you ll need to invest to guarantee a particular monthly payment, and you can get fast, free quotes.

But as soon as you start shopping for annuities, you ll realize that they can come with all kinds of bells and whistles attached. Some variations on the basic immediate-life formula can make sense. For instance, guaranteed minimum payouts: You can make sure your heirs receive annuity payments for up to five or 10 years if you expire in that time period, typically at a cost of reducing your payouts by a few dollars a month. This is a decent way of providing guaranteed income for at least a while to a surviving spouse.

Another example: inflation-indexed annuities, which start with lower payouts but increase over time to maintain their purchasing power. In our example, Patricia would probably have to accept monthly checks starting at about $550, not $700, to get an annuity with payouts adjusted for inflation. But those payouts would rise with time. At an inflation rate of 4 percent a year, their value would be greater than those from an unadjusted annuity after seven years. If you expect to live a long time and for your expenses to be dominated by inflationary items (such as medical care or property taxes, as opposed to, say, fixed mortgage payments), this can be valuable protection. To get a quote on inflation-indexed annuities, check out Vanguard s offerings at www.aigretirementgold.com.

Other twists aren t so helpful. With deferred annuities, you put money into an annuity contract but don t collect payments until years later. With variable annuities, you place your investment into stock and/or bond funds; their performance determines the amount of the payouts you get back; plus, you re guaranteed a death benefit. These kinds of products became very popular during the last bull market; sales of variable annuities hit a record $184 billion in 2007, according to Limra International, a financial-services consulting firm. Cathy Weatherford, CEO of the Insured Retirement Institute (IRI), says that variable annuities offer tax-deferred growth and exposure to equities. But when you let your annuity investment accumulate over time or subject it to the vagaries of the markets, you re giving an insurance company the chance to charge you investing commissions, insurance fees and surrender penalties. And the sum total of those costs has often proven to be wildly out of line with the benefits offered.

Recent studies suggest that, on the whole, variable annuities may not be wildly overpriced, but their fundamental rationale for existing is so screwed up that it doesn t really matter. Variable annuities dress up a product designed for safety with juicier investments. These days you can find annuity swaps, equity-indexed annuities, guaranteed minimum withdrawal benefit annuities and IRA rollover annuities, along with longevity insurance and managed-payout mutual funds. You re almost always better off buying an immediate annuity to take care of some retirement expenses (like the cost of long-term-care insurance), dispensing with transaction costs and investing your savings in low-cost diversified mutual funds.

Boring? With annuities, that s supposed to be the point.