Of all the products offered to investors, few are more controversial than variable annuities.

The conventional wisdom is that variable annuities are sold, not bought. In other words, if there were no annuity salespeople, investors wouldn’t buy them!

On the other hand, variable annuities can sometimes solve problems that other products just can’t.

An annuity is an insurance contract that lets investors set aside money that builds up without generating current tax liability.

As a tool for retirement planning, an annuity has two phases:

Accumulation and withdrawal, which is known as annuitization.

In the accumulation stage, you give money to an insurance company either all at once or in a series of payments, and it earns a rate of return.

That rate of return may be fixed in advance in what is called a fixed annuity.

Or it may be dependent on investments, as in a variable annuity.

In the withdrawal stage, you receive regular payments, usually for the rest of your life.

These payments may be guaranteed in advance, as in a fixed annuity, or may depend on investment performance, as in a variable annuity.

A fixed annuity is comparable to a bank certificate of deposit, with an interest rate guaranteed by the insurance company for a fixed period of time.

The investor’s return is known in advance.

A variable annuity is essentially a mutual fund account wrapped inside a thin layer of insurance.

The investor chooses from a variety of internal funds, known as subaccounts, the performance of which determines the return.

Annuities, like bank certificates of deposit, impose early withdrawal penalties on investors who take their money out before a period of time agreed up front.

A typical annuity has a surrender charge that declines year by year.

For example, a seven-year surrender period may impose a 7 percent fee if you bail out in the first year, 6 percent during the second year, and so on until there is no penalty after seven years.

The sooner you want your money back, the more you’ll pay in fees.

Although some variable annuities have no sales charge, most are load products.

Sales commissions on annuities are not itemized for the investor.

Typical commissions run from 5 to 5.5 percent of the money invested. And some heavily promoted “bonus” annuity contracts pay commissions up to 14 percent.

Because expenses inevitably reduce the investment performance of annuities, it’s important to know what they are.

One charge is for managing the subaccount or subaccounts.

The average charge is 0.8 percent a year, equivalent to a reasonably efficient mutual fund expense ratio.

Investing in Annuities

On top of that is an annual charge for insurance and operating expenses, averaging 1.1 percent. In addition, investors often must pay an annual contract fee of $30 to $50.

And some annuities impose charges for each time you swap money between subaccounts.

Most investors pay little attention to annuity expenses, and some people may think that a no-load, no-surrender-charge variable annuity invested in a Standard & Poor’s 500 Index fund is essentially the same as a mutual fund that tracks the index. Not quite!

Most variable annuities include an insurance feature that guarantees your investment if you die while holding the contract.

The cost of this insurance, formally called a “death benefit,” is rarely disclosed explicitly.

Instead, it’s included in an annual fee for “mortality and expenses.”

Every contract is different, but in all cases the insurance is quite limited.

In most variable annuities, it guarantees that if you die while you own the contract, your heirs will receive at least as much money as you originally contributed.

That might be valuable if you bought an annuity just before a big market drop and then you died before it recovered …

And this suggests a deathbed strategy:

If you unfortunately find yourself terminally ill with extra funds you want to leave to your heirs, buy an annuity and invest it as aggressively as you can.

If your investments are successful, your heirs will get the benefit; if your investments flop, your heirs will not suffer the loss.

Rates are guaranteed by the insurance company for a period of years, sometimes including a higher rate for the first year.

The longer guarantees generally have higher rates.

The guarantee of a fixed annuity may be tempting. But it might not be worth giving up the higher yields available elsewhere.

A fixed annuity is guaranteed by only one company.

However, the bonds held in a variable annuity subaccount are backed by many issuing companies.

Who do you trust more: one insurance company or 100 companies that issue bonds?

A fixed annuity can also guarantee a series of lifelong monthly payments in return for a lump sum, often when an investor retires.

It works this way:

In return for a one-time premium, an insurance company promises to pay you a set amount of money every month for the rest of your life.

In return, you give up whatever you paid as a premium.

That initial investment is gone, and you can’t get it back if you change your mind or your health suddenly turns bad and you realize you won’t live long.

The biggest risk when you take a fixed annuity payout is inflation.

Investing in Annuities

 Monthly income that seems quite adequate today is likely to be much less valuable in 15 to 20 years.

Even at a modest rate of 3 percent, inflation can reduce the purchasing power of $1,000 to $859 in five years, to $737 in 10 years and to $633 in 15 years.

After 20 years, that $1,000 buys only $544 of today’s goods.

Fixed payout annuities are fairly straightforward contracts, that guarantee a monthly payment for life.

If your health is uncertain or bad, a fixed annuity is probably not a good deal; but if you expect to live a very long life, an annuity may eventually give you “more than your money’s worth” from the insurance company.

But before you buy an annuity, consider whether you can afford to take the responsibility yourself of investing money to provide income.

If you are a buy-and-hold investor, don’t use annuities. Instead, use no-load index funds so you can get the benefit of long-term capital gains.

If you use market timing and plan to withdraw most or all of the money in your annuity while you are alive, an annuity may be to your benefit.

Market timing typically subjects much of your money to taxation at ordinary income tax rates.

That reduces your after-tax return substantially.

But in a variable annuity, your gains can build up in a tax-deferred environment, and you’ll almost certainly end up with more money.

If you use market timing and you plan to leave the annuity to your heirs, it’s hard to know in advance whether your heirs will get more from a taxable account or from a variable annuity.

That depends on several factors that are impossible to know many years in advance, including the size of your estate, the future income tax rate of your beneficiary, and what proportion of your estate the annuity makes up.

The most important recommendation is this:

Before you buy any annuity, fixed or variable, read the entire contract until you understand it.

Buy only after you understand the entire deal!

If you do that, you’ll maximize the chance that any annuity you buy will work for you, not against you!