When buying an annuity makes sense

NEW YORK (Money) -- Can you explain the value of owning an annuity? Most of my money is in the market, but I wonder whether it would make sense for me to own an annuity as well. -- Maria K. Sherman Oaks, Calif.

There are many different kinds of annuities, each with its own pros and cons (although certain varieties tend to tilt more toward the cons). But when it comes time to turn retirement savings into steady income, there is one type that stands out: an immediate annuity.

The basic premise is simple: In return for a lump sum investment, the insurer issuing the immediate annuity will send you monthly checks for the rest of your life. No other investment can make that claim. (For an estimate of the size of those checks, click here.)

On that basis alone, I think most people nearing retirement or already retired ought to at least consider putting a portion of their savings into an immediate annuity.

But an immediate annuity has other advantages as well. One is that it can generate a higher level of sustainable income than any other investment earning the same return.

Should I trust income annuities?

Yes, I know that seems implausible. But the reason is that when calculating payments, insurance companies know that some annuity buyers will die sooner than others.

So, in addition to factoring an investment return into each payment, insurers also include "mortality credits," which is a fancy way of saying they transfer money from people who depart this world early to those who stick around longer. Those mortality credits can represent a substantial portion of an annuity's payments, especially if you live a long life.

But perhaps the most compelling reason to consider an immediate annuity is that by combining one with a traditional portfolio of stocks and bond funds, you have a better chance of generating a higher level of sustainable income than you would by putting all your money in stock and bond funds alone.

The reason is that the annuity generates steady income that takes the pressure off a stock-and-bonds portfolio during market setbacks. That's an important consideration given some of the major tumbles the financial markets have taken the past dozen or so years. (To see how the combination of an immediate annuity and a traditional portfolio can make your savings last longer, click here.)

Immediate annuities do have potential downsides, however. A biggie -- and the deal breaker for many people -- is that you're giving up access to your money once you hand it over to the insurer for the annuity payments. So you can't dip into it for emergencies and such. Nor is that money available to your heirs.

Simplify your retirement savings

So if you die soon after buying the annuity, you'll have put out a lot of money for relatively few payments. Most annuities offer options that allow payments to continue for a time after your death or that even refund a portion of your investment to your beneficiaries. But either way it will mean accepting a lower payment, which undermines the point of doing the annuity in the first place.

Another drawback is that you're depending on the financial strength of the insurer to provide those payments for the rest of your life.

After the experience of the 2008 financial crisis when the government had to step in to shore up giant insurer AIG, I can understand why people may question whether they can really count on an insurer to make payments for the next 20, 30 or even 40 years.

But there are ways to deal with these issues. You can assure that you have sufficient liquidity for unanticipated expenses, for example, by putting only a portion of your savings into an annuity, leaving the rest invested in a portfolio of stock and bond funds.

How long will my retirement savings last?

If leaving money to heirs is a major concern, you can just set aside whatever you would like to pass on. As for the possibility that an insurer may not be able to make its promised payments, you can mitigate that risk by diversifying.

First, divvy up however much you intend to devote to an annuity among annuities from two or more insurers that get high ratings from firms like A.M. Best and Standard & Poor's.

And for an additional measure of comfort, make sure you invest no more with any single insurer than the maximum coverage provided by your state's insurance guaranty association.

I want to be clear, though, that I'm not suggesting an immediate annuity should be part of everyone's retirement income plan. If your nest egg is so large that you can draw enough money from it without any real dangers of ever running out, then an annuity's probably not for you.

Similarly, if you can maintain an acceptable standard of living in retirement on Social Security and any pension income alone, then you probably don't need an annuity either.

But if you're retired or nearing retirement and want more assured income than Social Security and pensions will provide, I think it makes sense to at least think about putting a portion of your savings into an immediate annuity.