Despite this year’s positive stock market performance, many retirees and near-retirees are still reeling from the long market decline and lamenting what might have been had the bubble not burst. There are plenty of anecdotes of retirees having to return to work and make significant lifestyle adjustments due to investment losses. Throw in the current mutual fund scandals and investors are understandably wary. The burning question is no longer “how can I make the most money?” but is now “how can I just make sure I have enough income to take care of myself in my remaining years?’.

An appealing way to address this concern is to “annuitize”, or enter the payout phase, of an annuity. The payout phase is an agreement in which an insurance company will pay the annuitant (the investor) a fixed monthly or annual amount for the rest of the annuitant’s life. The contract is guaranteed by the insurance company, and the insurance company usually retains the initial investment regardless of how long the payments were made. (Payments can be extended through a variety of payout options, but the payment amount is correspondingly lower.)

As with all investments, though, there are disadvantages to this arrangement. The “guarantee” is only as good as the credit quality of the insurance company, and this can erode over time. While failures are rare but not unprecedented (recall Executive Life and Mutual Benefit Life from the early 90’s), credit problems can create disruptions and delays in annuity payments.

Annuities are illiquid; there is no provision to end an annuity contract once the payout phase begins. There is no secondary market to trade annuities, and so the annuitant is committed for life. Other illiquid investments typically offer a premium, or higher return, to the investor as compensation for a long-term commitment. Annuities do not offer such a premium.

Annuity payments are based on two factors – the insurance company’s expected return on their investment portfolio and the annuitant’s life expectancy. If the annuitant outlives this expectancy, he “wins”; if he dies early, the insurance company wins. Although annuity purchasers do so out of fear of outliving their money, the opposite is just as likely. Your estate gets nothing unless you choose a “term certain” annuity, which guarantees that either you or your beneficiary will receive payments for a certain period of time, such as 10 or 15 years. But these contracts do not guarantee lifetime income.

Alternative investment strategies can achieve the same goals with less risk and greater flexibility. A portfolio of government and high-quality corporate bonds could yield more than an annuity and the investor would still retain much of the principal. Likewise, a “total return” approach maintains a properly diversified portfolio of stocks, bonds and cash. A steady percentage of the portfolio can be liquidated each year, depending on the investor’s age, and used to support disciplined spending.

In fairness, though, we often talk about the value of peace of mind, and annuities score well in this regard. If an annuity seems to meet your needs, there are several factors to consider. Except in extreme cases, no more than 25% of the overall portfolio should be committed to an annuity. This will provide some predictable income but still leave the investor with the ability to deal with unanticipated changes and other estate planning goals.

The credit quality of the insurance company should be a primary criteria in choosing an annuity. Ratings from agencies such as Standard & Poor’s, Moody’s, Fitch and A. M. Best are readily available. In addition to the credit rating, apply the same logic you would with any other investment – if one annuity promises to pay considerably more than others of comparable rating, there must be a reason. Take the time upfront to investigate and understand these differences.

Finally, the older and healthier the annuitant, the better. Delaying the payout phase gives the portfolio more opportunity to grow, possibly reducing the dependence on the annuity payments. Older annuitants receive larger payments, often significantly so, and are better able to judge how likely they are to outlive the standard life expectancy. They also have a better handle on their income requirements. Younger annuitants face greater uncertainty and have less information to make these decisions.

Under the proper circumstances, an annuity can help provide the comfort of knowing where retirement income is coming from. Be careful of seductive sales pitches, and if necessary enlist a financial advisor to help you weigh the pros and cons.