If you believe their critics, annuities are a big ripoff — financial vehicles that are flogged by financial advisors merely for their high commissions. This is unfortunate, for annuities (both fixed and variable) can be useful financial planning tools — well, when used carefully and correctly. And that's the problem. Annuities are easily misused — so much so that annuity sales are drawing the interest of regulators (see related story page 68.)

Like any other financial product, whether an annuity is right fit for your client depends on a host of factors, such as age, net worth (and liquidity), annual income (tax bracket), tolerance for risk, level of financial sophistication and intended financial objectives. In general, I use annuities sparingly in my own practice, but there are four sets of circumstances in which an annuity offers an attractive alternative relative to mutual funds.

One such circumstance is when interest rates are low; fixed annuities have provided attractive alternatives to fixed investments of similar maturities. Some brokers may be surprised to learn that many insurers are offering fixed annuity rates exceeding rates found on CDs or government bonds of the same duration.

Additionally, annuities generally pay interest on a compounding basis, netting greater total yields than government or corporate bonds, which typically pay coupons semiannually. As such, it would behoove you to explore this investment option for any of your clients that invest in fixed income products. Recognize, however, that if your client takes a lump sum distribution, he will absorb the entire net return as income in that year. This has the potential to increase your client's income sufficiently, placing him in a higher tax bracket and thereby reducing the total after-tax return you had strived to achieve.

Perhaps the most useful benefit of an annuity is its potential for lifetime income. A legitimate concern for most retirees is whether they will outlive their assets. An annuity's lifetime income option can help alleviate this potential lifestyle threat. Under this option, an annuitant will be provided an income stream that the insurer will provide for the remainder of his/her life — no matter how long that is. A truly wonderful benefit, it can provide substantial peace of mind for retirees living off their savings.

Of course, there is a price to pay for this option. While the issuer will pay for as many years as the annuitant lives, they will cease payments at the annuitant's death. If the annuitant passes away soon after annuitizing his/her contract, the insurer has made a tremendous profit and the annuitant's estate is left shortchanged.

To counterbalance this scenario, insurers began offering certain term options. Under these, an annuitant is guaranteed to receive payments for a certain term of years, perhaps 10 or 20.

Another tax-advantaged benefit of annuities can be found through use of the 1035 exchange privilege. Internal Revenue Code section 1035 allows that transfers between annuities and insurance contracts can avoid current taxation. A common situation in which this is necessary: a client has a cash value life insurance policy for which he no longer has use for the death benefit. In certain situations, the actual cash value may be of more value to your client than the insurance death benefit, and the client can place this cash value into an annuity and avoid current taxation.

Yet another annuity-friendly situation is when a client wants to invest for growth, but absolutely insists on a protection of his principal investment. Many insurers offer some feature or rider in their annuities in which they agree to refund a client's premium investment after some period of time should they maintain a net negative return in the contract. (Some contracts only offer this benefit as part of an annuitization option, so performing your due diligence in this circumstance is necessary.) In our current financial climate of historically low interest rates, an annuity may offer a superior alternative to protecting a portfolio with zero-coupon bonds.

Rounding Out the Field

Finally, there is an option for younger people. In the case of a young adult who has inherited money, for instance, committing some funds to an annuity creates a form of escrow account for their retirement. While I would not always recommend this as the first course of action, those lacking in fiscal discipline may require an account in which it is difficult to obtain access to the funds. The potential consequence of large taxes and penalties can keep someone from invading annuity account values.

To be sure, annuities have downsides. They are not FDIC insured, as most CDs are, nor are they backed by the full faith and credit of Uncle Sam.

However, they do carry the weight of the claims-paying ability of the issuer, namely the insurance company offering them. This means you must perform above average due diligence not only on the annuity instrument itself, but also on the company backing it.

Given the increased scrutiny of financial products and sales practices, all brokers and agents need to put forth extra effort in this regard.

But regardless of what you may read or hear on the news, annuities are not evil. Even a skeptical soul like myself can assure you that annuities, both variable and fixed, play an important role in the financial product marketplace, and they can be a very useful planning tool.

Michael F. Greco, CFP, is a partner in GCI Financial Group, a financial planning agency located in Maplewood, N.J.