How to choose an annuity: if carefully constructed, an annuity can be an important part of your retirement plan--but they're not right for everyone.

Pathologist Arthur Bracey works in an environment of rising malpractice judgments. But he's no longer worried that an angry patient filing suit against him could take part of his near $200,000 yearly salary.

Why the peace of mind?

In June 2002, Bracey, 52, purchased The Best of America variable annuity from Nationwide Insurance Co. in Columbus, Ohio. Like many doctors, Bracey realized that just one lawsuit could radically alter his life, so he chose a variable annuity to protect his income. With this particular annuity, Bracey can contribute an unlimited amount of money each year and still have the annuity legally protected against lawsuits that may be filed against him personally or professionally. Such protection allows his wife, Annette, 47, to stay home and care for their two children, after working more than 17 years in the public health industry.

In addition to legal protection, the annuity gives Bracey control over where his money is invested and how the assets are divided. He also enjoys lower federal income taxes, which is a huge plus since Bracey's earnings put him in the 35% tax bracket.

"This offers great security," says Bracey, who practices medicine at St. Luke's Episcopal Hospital in Houston. "This is how high-profile people protect assets."

Bracey is using an annuity to protect his income, but each year, many Americans purchase them because they address multiple financial goals. According to the Insurance Information Institute, an insurance industry agency that monitors sales, investors put $223.1 billion into annuities in 2002. These investors included those still scaling the ladder of success and those on the brink of retirement. But while banks and other financial institutions encourage a younger generation to buy annuities, experts agree that this type of investment tends to make more sense for those closer to retirement, generally age 50 and older.

Annuities are personal retirement vehicles that allow the owner to accumulate money in tax-deferred investment accounts and also to withdraw funds before his or her death. They used to be defined by two categories: fixed annuities, which guarantee a minimum return (usually 3%) or minimum monthly payment, and variable annuities, which allow the owner to invest money in stock and bond mutual funds with the hope of securing a higher return. Fixed annuities are the safest option. Variable annuities are riskier because their rates of return fluctuate with the market.

Last year, there was a push by several insurance companies to expand the categories of annuities in answer to growth-hungry, yet market-shy, investors. The result: hybrid annuities that are part fixed annuity and part variable annuity. Also, for an additional fee, insurance companies will tack on long-term care policies, principal guarantees that can be adjusted annually, and some control over investments.

DETERMINE YOUR FINANCIAL GOALS

Annuities are not for everyone. To decide whether they make a good fit for you, first consider your financial goals. What do you plan to do with the money? Use it for your retirement? Hand it over to your kids as an inheritance?

Don't skip this crucial step. Prioritizing your goals is key because of the variety of available products. Once your goals are outlined, start shopping around, but be careful.

"There's no truth in lending as with credit cards, or good faith estimate as with mortgages," says Cheryl Creuzot, president and CEO of Wealth Development Strategies L.P. in Houston.

CONSIDER THE COSTS

When shopping for an annuity, compare the costs involved with other investment options. Keep in mind that annuities are usually the most expensive.

According to Morningstar Inc., an investment research firm, insurance companies charge an average of 2.27% in insurance and money management fees on variable annuities, while the average mutual fund charges only 1.44%. Lipper, a Reuters company that specializes in mutual fund analysis and commentary, further indicates that even the income-producing annuities that are most comparable to fixed annuities charge an average 1.91% in fees.

Moreover, like back-end loaded mutual funds, annuities charge owners for withdrawing money in the first few years. But the annuity penalties, called surrender charges, are staggering, typically ranging between 5% and 7% in the first year. They usually decline by one percentage point each year, according to the National Association for Variable Annuities, a nonprofit trade association that promotes variable annuities.

Audrey Mitchell Carruthers, 46, says the daunting surrender penalties force her to refrain from withdrawing money from her annuity. While she was in her 30s, Carruthers liked to shop and found it hard to leave her savings alone. So when she got a $30,000 lump sum payment, she worried about it trickling away in a flurry of shopping bags. That is until 1994, when a financial adviser mentioned that she might be interested in purchasing a variable annuity. Carruthers, who earns $76,200 a year as an internal budget analyst for Bell South Financial in Atlanta, saw an opportunity to keep herself from dipping into the money.

It worked. And Carruthers became so proud of her growing portfolio that she began investing in other products. Today, she maximizes contributions to her 401(k) and IRA and is investing in a 529 college savings plan for her 8-year-old son, Kyle.

CONSIDER YOUR AGE

While many banks and insurance companies with financial goals of their own pitch annuities to young people, most financial advisers do not support the purchase of annuities by those younger than 40. Since younger investors tend to have growing families with more occasional cash crunches, they may be tempted to withdraw early from the annuity, stacking up unwanted surrender charges.

Marvin Mangham, a registered representative for Investors Capital Corp. and a principal at The Atlanta Planning Group, says annuities make more sense for the person pushing retirement; therefore he does not promote them to very young people.

"They have limited uses in a portfolio--that is, they are useful if you have a large amount of money that you really want to grow tax deferred and have no use for except to supplement retirement," he says.

Mangham admits that despite his feelings about young annuity holders, he chose to support Carruthers' decision to keep her annuity when she solicited his services in 2002 because he knew that she intended to hold on to it untouched until retirement. Some people Carruthers' age simply do not. For that reason, financial advisers have specific instructions for people who are interested in annuities but who are far from retirement age.

"If they have maxed out a 401(k) and Both IRA and are looking to shelter money for retirement, then someone in their 30s should look at variable annuities if they can leave it in until they're 59 1/2 to avoid federal penalties," says Sam Gott, a registered investment adviser, certified financial planner, chartered life underwriter, ChFC, LUTCF, and AAMS in San Antonio. "Most people are not going to be able to max out the others."

As for retirees, AARP warns against investing in variable annuities that can lose all their value because they have less time to recoup any losses caused by market swings.

However, Pamela Bonds, investment representative at Edward Jones in Olivette, Missouri, encouraged Cozy and Shirley Marks, both 71, to upgrade to a new variable annuity last year because it gave them a chance to meet their multiple goals while offering security.

The Markses live in St. Louis. He is a retired public school administrator. She earned a living as a health center manager. After they watched the value of the Hartford Group variable annuity they had been investing in since the 1970s drop from $600,000 in the mid-1990s to $351,000 in the spring of 2002, they brought on Bonds to represent their financial interests.

"I wanted to know what I could do to stem the tide," says Cozy.

But the Markses also wanted access to cash in case one or the other was incapacitated and needed long-term care. And they wanted the money to keep growing as an inheritance for their grandchildren.

Taking their needs into consideration, Bonds moved the Markses into a newer Hartford variable annuity that charges 0.35% to guarantee the principal for 25 years and allows them to increase the base guarantee every five years. They also pay 0.95% for the basic insurance and 2.5% in front-end loads each time they make a deposit into the mutual fund-like sub-accounts.

Bonds sells cheaper fixed annuities but says she recommended the more expensive variable annuity primarily for the guarantee. "The only reason to do this is the preservation of principal," she says. "If this were my morn, I would want to be able to say, 'This money will last you.'"

PROCEED WITH CAUTION

Even if annuities seem right based on investment goals and age recommendations, investors must carefully approach the selection process. (See sidebar, "Seven Steps to Selecting an Annuity.")

Be leery of opening guarantees that are higher than the current average rates. They could represent a signing bonus that will vanish in subsequent years. Creuzot advises checking the annuity's renewal history. "Someone's got to question how a company would be able to offer a rate significantly higher than the current standard," she says.

To research the renewal history showing what guarantee rates are issued at renewal time, check the Website of the insurance company that's issuing the annuity or visit www.annuityadvantage.com.

Keep track of which annuities are becoming less popular. Even the stalwarts, fixed annuities, are losing their attractiveness. Insurance companies have used the recent plunge in interest rates to convince the National Association of insurance Commissioners to endorse cutting the minimum guaranteed returns on fixed annuities by half, to just 1.5%. Several states are moving to switch to the lower rate. "That takes a lot away from a fixed annuity," says Gott.

7 steps to selecting an annuity

step 1

What do you want to do with the money? If you're saving for retirement, go to Step 2. If you're hiding money from potential litigation, check your state's laws. In some states, annuities are exempt from seizure against lawsuits and bankruptcy. If this is the case in your state, go to Step 3. If you're setting aside money to leave as an inheritance, first check term and whole life insurance policies, particularly if you're young. If you're trying to protect principal, first check the costs of new principal-protected mutual funds or CDs that are partly invested in the stock market If you're saving for short-term needs, choose another investment option because the IRS charges a 10% penalty if the money is withdrawn before age 59 1/2. Insurance companies also deduct surrender penalties unless the withdrawal is due to the holder's death or disability.

step 2

Have you maxed out other tax-deferred savings options, including 401(k) and 403(b) plans and SEP, Keogh, traditional, and Roth IRAs? If yes, proceed to Step 3. If no, max out these cheaper options first.

step 3

Which is more important: guaranteed payments or maximizing growth? If guarantees are paramount, choose a fixed annuity because the risk is lower. Otherwise, consider a variable annuity or hybrid.

step 4

Get a broker salesperson to provide comparative data. For fixed annuities, compare how long you would pay surrender penalties, starting dates of surrender penalties (at signing of contract vs. when each deposit is made), percentage of guaranteed return, length of guarantee, typical rates at renewal, and financial rating of insurance company (limit choices to ratings of A and above). For variable annuities, also look at annual insurance fees (often labeled M&E charges) and annual management charges for the portfolio.

step 5

Pick the cheapest annuity with the best guarantees based on the investment goal identified in Step 3. Fixed annuities usually charge about $30 a year in administrative fees. For variable annuities, those fees are built into M&E charges.

step 6

After the surrender period has ended, review annuity terms against newer annuities. Most insurance companies deduct a surrender penalty if you switch before the surrender period ends, except when the owner begins receiving annuity payments. You can switch between annuities without paying federal tax penalties by filing Form 1035 with the IRS.

step 7

When you're ready to start taking annuity payments, shop around for the best annuity payment plan--which could very well be the annuity you're with.