(MONEY Magazine) – Back when the bull market was propelling our retirement savings on a seemingly unstoppable upward trajectory, annuities were one of the hottest investments around, racking up sales gains of 20% a year. So now that we're more concerned with protecting our retirement stash, what investment is generating the big buzz? Annuities again, with sales gains of 60% in the first half of this year.

How is it possible for one in-vestment to appeal to so many investors in both up and down markets? Simple. We're talking about two different types of annuities. In the late '90s, investors were pouring their dollars into variable annuities, which combine tax-deferred growth with the same investment choices you find in mutual funds. These days, investors are flocking to fixed annuities, investments designed more for capital preservation than growth.

Which leads to a natural question: Given their popularity, should annuities be playing a role in your retirement portfolio? There's no doubt that they can provide a wide range of benefits you can't find gathered together in any other single investment: the tax deferral of 401(k)s and IRAs with virtually no limit on how much you can invest; a shot at long-term capital gains; the ability to protect capital when markets head south; and something that only annuities can offer, an income you can't outlive.

Problem is, those benefits come with lots of baggage. Return-zapping fees, onerous withdrawal penalties, gimmicky options of dubious value and sheer mind-numbing complexity can blunt annuities' advantages and even make them totally inappropriate for many investors. Still, as more low-cost versions have become available in recent years, many people, myself included, who dismissed annuities outright now believe that their guaranteed-income feature can make them a good investment. "A year ago, I would have washed my mouth out if I said the word annuities," says Coral Gables, Fla. financial planner Harold Evensky. "Now I believe they can be an important part of retirement planning."

In this buyer's guide, we'll explain how these complicated investments work, so you can decide whether one is right for you. But before we get to that, there are a couple of general things you need to know about them up front.

First, when you invest in an annuity, you are taking on a partner--the insurer that issues it. To assure that the insurance company has the financial wherewithal to stand behind its annuity, stick with companies that receive high financial strength ratings from firms like Standard & Poor's, Moody's Investors Service and A.M. Best. This is especially important today as many insurers have been rocked by the double whammy of losses in the stock market and in the bonds of companies like Enron and WorldCom. The resources box on page 110 will tell you where to get insurers' ratings and other information to help you evaluate annuities.

You should also know that annuities are unique in the investment world in that they can have two distinct stages. Their tax-deferral feature can help you accumulate assets for retirement, and their payout feature can then help you turn those assets into income. If you're sure that you'll eventually want a guaranteed income, you can invest in an annuity in your forties, or even earlier, and then convert your stash to income when you retire. But if unexpected financial demands force you to bail out of your annuity early on--and by early I mean within 15 or 20 years--the combination of fees and taxes may leave you with less cash than if you had simply bought a mutual fund. So unless you're sure you can hang in until you convert your balance to monthly payments, you should wait until you're closer to retirement to buy an annuity. Or you can wait until you've actually retired and take cash from other investments to buy an "immediate" annuity, one that starts payments at once.

Since annuities can play this dual role, I'll divide our review into two parts, the accumulation stage, then the payout phase. So sit back and read on to see if annuities should play a role in your retirement savings plan.

BUILDING WEALTH WITH ANNUITIES

When it comes to building assets for retirement, you have a choice of two types of annuities: fixed and variable. Since each type raises different issues and requires different analysis, we'll examine them separately.

FIXED ANNUITIES: Fixed annuities are essentially CD-like investments issued by insurance companies. Like CDs, they pay guaranteed rates of interest, in many cases higher than bank CDs. In September, for example, annuities yielded 4% to 6% on average vs. 3% to 5% for CDs, and some insurers offered bonuses that pushed yields into double digits. Throw in their low investment minimums--usually $1,000 to $10,000--and the fact that the interest they pay escapes taxation until you pull it out, and it's no wonder people tired of seeing their savings pummeled in the stock market have been snapping up fixed annuities like never before.

But fixed annuities come with a variety of catches that can undermine the very features that draw you in. Take their rates. They're guaranteed, all right, but for how long? In September, for example, the FPDA 88 fixed annuity offered by Conseco touted an extraordinary 12.05% rate, which consisted of an 8% bonus for the first year on top of a "base" rate of 4.05%. But look closer and you find that not only is the bonus rate good for just one year, but so is the 4.05% base. After 12 months, Conseco can reset that base rate wherever it wants (although like most annuities, it guarantees a minimum interest rate of 3% a year). In short, for the promise of a lofty rate for one year, you're accepting a future of uncertainty. And this is how most fixed annuities work whether they offer a bonus or not: You get an attractive rate for the first year, but beyond a minimum of 3% or so, you're pretty much at the insurer's mercy when it comes to renewal rates.

That might not be a problem if you could just bail out if you don't like the new rate. But doing so can be costly. That's because with one exception--the fixed account in TIAA-CREF's Personal Annuity Select--fixed annuities have surrender charges for early withdrawals that typically kick in if you pull out more than 10% of your account value in any one year. These charges usually start at 7% or so and disappear after seven to eight years, although they can go as high as 12% and run as long as 10 years, as is the case with the Conseco annuity. Many annuities also levy an MVA (market-value adjustment) for early withdrawals, a provision that docks your account if interest rates have risen since you bought your annuity. So you could get hit with an MVA plus a surrender charge. (If rates have fallen since you bought your annuity, the MVA would boost your account--and the surrender charge would apply to the higher amount.)

The upshot: If you bail out of your annuity early, the various withdrawal charges could wipe out much, and in some cases all, of your return. Assuming that you do manage to come away with earnings, you would then owe taxes on your gain, plus a 10% federal tax penalty, if you're under age 59 1/2.

There is a way, however, to lock in a fixed rate of return for a specific period. Buy a "CD annuity." This version guarantees a rate for a specific term, usually anywhere from one to 10 years. CD annuities still have surrender charges, but they typically disappear by the end of the term. So if you don't like the renewal rate when the term expires, you at least have the option of bailing out without paying a surrender fee.

BOTTOM LINE: When it comes to building savings for retirement, fixed annuities should probably play a minor role at best as a CD substitute in the conservative part of your portfolio. Even then, they may be more trouble than they're worth, considering how easily surrender charges, market-value adjustments and tax penalties can undo whatever rate advantage they may have on CDs. To the extent you use them at all, you're better off with a surrender-charge-free version like TIAA-CREF's fixed account, or CD annuities.

VARIABLE ANNUITIES: Unlike their fixed counterparts, variable annuities are designed to pump up your savings by giving you a chance for long-term capital growth. They do this by allowing you to invest in anything from half a dozen to 20 or so stock or bond mutual-fund-like portfolios called subaccounts, many of which are run by such established fund managers as Strong Opportunity Fund's Dick Weiss and Templeton emerging markets guru Mark Mobius. As with fixed annuities, gains escape taxation until withdrawal.

If the story on variables ended here, they would be no-brainers. But they too have several drawbacks that can erode their advantages, starting with taxes. As with fixed annuities, you'll pay taxes on variables' gains when you withdraw them, plus a 10% penalty if you're under age 59 1/2. Variables also have another little tax twist: Any long-term capital gains you build up in stock and bond subaccounts are taxed at ordinary income rates when you withdraw them. This means that high-income investors are effectively converting capital gains taxed no higher than 20% into ordinary income that can face rates as high as 38.6%.

And then there are variables' fees. Aside from surrender charges that dock you for early withdrawals, variables come with two whole other layers of expenses. First, there are the management fees for running the subaccounts, which typically range from 0.5% to more than 2% in the case of some international and small-cap portfolios. Then there are insurance charges, which average 1.3% but can run as high as 1.6%. Combine the two, and variable annuities' total annual expenses can easily weigh in at more than 2% and sometimes tip the scales closer to 3%. It's because of these fees and the tax treatment of capital gains that it can take 15 years or more of tax-deferred buildup before a variable annuity delivers a higher after-tax return than a mutual fund.

Fortunately, there's been some progress on the fee front in recent years as a small but growing number of companies have begun offering annuities with far lower expenses and, in many cases, no surrender charges. You'll find a table of these low-cost annuities on page 106.

As if buying a variable annuity isn't daunting enough, you also have to sift through the various options insurers tack on. One favorite: the death benefit. Most annuities come with a bare-bones death benefit that guarantees that when you die your beneficiary will receive the higher of the market value of your account or the amount you invested. But most insurers try to sell you an enhanced version that guarantees the greater of your account balance or the value of your investment compounded by 5% or 6% a year.

Another feature insurers are pushing hard these days is the GMIB, or guaranteed minimum income benefit. Here the insurer typically promises that if you hold your annuity at least 10 years, you will receive a guaranteed level of income in the future, even if your subaccounts perform abysmally.

Such provisions undoubtedly have an emotional appeal. Who wouldn't want to lock in a retirement income in advance or protect heirs against market downturns? But the real issue is whether these features are worth their cost. For your beneficiary to collect on the death benefit, for example, two things have to happen simultaneously: The market has to fall far enough so that your account is worth less than your original investment and you've got to drop dead while your account value is down. That's not to say this can't happen--I'm sure some lucky beneficiaries have collected on the death benefit during this bear market--but the odds are long.

As for the GMIB, the operative word is "minimum." If you read through the fine print in the contract, you'll find that the income the insurer is guaranteeing is exceedingly small. Combine the low probability of collecting on such features with the fact that they can boost annuities' already lofty costs by 0.25% to 0.5% a year or even more, and it's difficult to justify them on economic grounds.

BOTTOM LINE: If you've already maxed out your contribution to 401(k)s and IRAs--both of which provide tax deferral without annuities' extra layer of fees--then variables can be a good way to boost your savings for retirement. To get the most out of them, however, you should limit yourself to ones with low annual fees and forgo expensive options that dampen long-term growth potential.

CREATING INCOME WITH ANNUITIES

After building up your annuity account balance, you have several choices for getting your money out. You could just surrender the annuity for cash or take out money as you need it. But if you choose either of these options, you would be giving up the one feature of annuities that no other investment can offer--namely, the right to "annuitize," which is insurance-speak for converting your balance to a guaranteed lifetime income. You could also be giving up a valuable tax benefit if you pull out your money all at once or take sporadic withdrawals. That's because when you annuitize, a portion of each monthly payment is considered a return of your original capital and goes untaxed, boosting the after-tax value of your monthly payments. (You don't get this tax break if you annuitize money in your 401(k) or IRA, since you already got a tax benefit when you made the contributions to your account.)

This lifetime income guarantee comes with a trade-off, however: You must give up access to your money. So to maintain wiggle room for emergencies and the like, you want to have plenty of other assets outside the annuity.

As in the accumulation stage, you have two basic choices: a payment that will remain the same for life or one that will fluctuate but also has the possibility of going up over time.

FIXED PAYOUTS: The premise behind a fixed-payout annuity is simple. You turn over a sum of money to an insurer, and the insurer gives you a fixed payment, typically each month, for the rest of your life. (You could also choose to get payments as long as you or your spouse are alive or for a specific number of years.) The size of your payment depends on several factors, including your life expectancy and the current level of interest rates. At recent rates, for example, a 65-year-old man annuitizing $100,000 would receive a guaranteed payment of $700 to $750 a month for life, depending on the insurer.

While locking in a guaranteed income may seem like the safest option, you're actually leaving yourself exposed to several risks. If you happen to be annuitizing at a time when rates are at or near historic lows, as they are today, you could be locking in a relatively small payment for the rest of your life. To protect yourself, you should annuitize several chunks of money over a few years at different interest rates.

No matter what size payments you lock in, a fixed payout still leaves you vulnerable to inflation. If prices were to increase at just 2% a year, for example, the purchasing power of the $750 a month that a 65-year-old could get today would decline roughly 40% over 25 years.

BOTTOM LINE: Combined with Social Security and any pensions you may draw, a fixed-payout annuity can provide a retirement safety net, a minimum level of guaranteed income that you can count on to cover much of your essential living expenses. But since your living expenses are almost certainly going to grow over time, while your payout remains the same, you'll need to set aside assets in other in-vestments, such as mutual funds, that can provide liquidity for unexpected expenses. Ideally, you may want to combine your fixed-payout annuity with a variable-payout version, which can generate payments that will outpace inflation.

VARIABLE PAYOUTS: A variable-payout annuity also guarantees payments for life, except that those payments fluctuate from month to month. For giving up the security of knowing what your payment will be each month, you gain something valuable in return: the potential for your payments to grow over time.

Admittedly, an annuity with payments that can go up and down each month isn't the easiest concept to get your mind around, but here's a quick rundown on how such annuities work. You start by choosing an assumed interest rate, or AIR. This acts as a benchmark that, along with other factors such as your life expectancy, helps determine the size of your first monthly payment. Many insurers let you pick your own AIR--usually between 3% and 6%--while others simply assign one. Next, you divide your account balance among various stock and bond subaccounts. If the subaccounts that you've chosen earn a higher rate of return than your AIR, your monthly payments increase. If your subaccounts earn less than the AIR, your payments decline.

Choosing a high AIR will give you a bigger payment initially, but that also sets a higher performance bar, making it more difficult to boost payments later on. If you want your payments to grow, you are better off choosing a lower AIR.

Once again, you've also got to consider fees. Even though you're now drawing income, the insurance charges and management fees that I talked about earlier are still being charged to your account. And since your return after expenses determines your payments, you have a better chance of seeing your income grow with a low-expense annuity.

Although variable-payout annuities do a good job of keeping your payments ahead of inflation, they still have some drawbacks. Payments can drop precipitously during market downturns. And once you start drawing income, you give up access to your account balance.

In recent years, many insurers have added features to deal with these issues. Lincoln National Life's American Legacy annuity, for example, allows you to chose an access period that typically ranges from five to 30 years, during which you can tap your annuity for cash. T. Rowe Price's variable annuity, meanwhile, contains an option that provides limited access to your account and guarantees that your income will never fall more than 20% below your initial payment.

Like comparable options in variable annuities during the accumulation stage, however, these features drive up costs. Lincoln Life's access feature adds 0.4% to the insurance charges, while T. Rowe Price's minimum payment option costs an extra 0.85% a year. So in return for access to your money and protection against occasional market setbacks, you're limiting the growth of your payments.

BOTTOM LINE: A variable-payout annuity is an excellent way to assure yourself a retirement income that you can't outlive and that has a good shot at growing faster than inflation. To increase the odds that your payments will grow over a retirement that may last 30 years or more, however, you should opt for annuities with low fees and skip all those expensive options.

Clearly, annuities require more attention to detail than other investments. But once you strip away the fees, the tax advantages and disadvantages and those gimmicky options, you'll find one feature that's unique to annuities: an income you can't outlive. And when it comes to planning a secure retirement, that may be the most valuable benefit of all.