Annuity Scrabble Simon Cunningham
Image: Flickr user Simon Cunningham.

Annuities can be confusing to many investors, and one reason for confusion is that the way that the industry assigns multiple names to certain types of products can obscure their true meaning and purpose. The hybrid annuity is a good example, as the name sounds modern but doesn't say what the annuity actually offers. Before you buy a hybrid annuity, here are five things you should understand that can help you assess whether you really need the product.

1. What is a hybrid annuity?
Perhaps the most troubling thing about hybrid annuities is that there's no consensus even within the industry on exactly what one is. Most experts point to multiple types of hybrid annuities, but their purposes can vary greatly. For instance, some see fixed annuities that have a guarantee of minimum lifetime income as a hybrid, as they offer the predictability of a fixed annuity with the even greater protection against adverse market conditions that a lifetime income guarantee provides.

Yet others see hybrid annuity products as being a variable annuity that combines exposure to different financial markets, such as both the stock market and the bond market. By using a more diversified underlying target, returns on these annuities won't be as volatile as on a typical single-asset-class variable annuity. At the same time, though, this makes the guarantee less costly for the insurance company, as you'd expect less overall volatility in a balanced portfolio than you'd get with a portfolio that was 100% invested in stocks.

Before you buy what your insurance salesman is calling a hybrid annuity, make sure you know exactly what it consists of. Otherwise, you might think you're getting one thing while actually buying a much different thing.

2. Know the risk and reward.
Many hybrid annuities offer exposure to a given market, but in exchange for limiting potential losses, they tend to put a cap on potential positive returns. Therefore, it's critical to know how much of an index's gains you'll get to keep.

For instance, some products offer 100% participation up to a certain point, while others have higher upside limits but pay you less than 100% of the benchmark index's returns. Without knowing the risk and reward, you won't know if a given product is really suitable for your needs.

3. Some hybrid annuities can create losses for you.
Many annuity buyers get used to products that ensure protection of principal. That's often worth the cost for many buyers, as they prefer not to take any market risk at all.

Yet one thing to keep in mind is that various providers offer different sorts of benefits, some of which involve the buyer taking on the risk of loss. In general, the greater the loss you're willing to take on, the greater the potential reward if the market is favorable. Nevertheless, the worst outcome is a loss you didn't expect, and so you can't afford to neglect understanding the risks of loss of principal with a given hybrid annuity.

4. Hybrid annuities give you many benefits of annuities generally.
One reason why annuities are so popular is that they offer tax advantages over some other investments. The tax code gives annuities preferential treatment, essentially making them tax-deferred vehicles as long as money stays within an annuity contract. Moreover, tax-free exchanges to other annuities allow you to shift gears without a taxable event, unlike many regular taxable investment accounts.

5. Hybrid annuities have many of the pitfalls of annuities generally.
At the same time, though, hybrid annuities share many of the less desirable traits of other annuities. Many come with extensive surrender charges if you try to cash them in within a certain number of years, as annuity companies treat them as long-term investments. Other annuities will let you get access to a portion of your capital at various intervals, but you have to follow the rules in order to avoid costly fees.

Overall, the hybrid annuity is an insurance vehicle that can be hard to understand. Rather than fixing on the hybrid annuity name, it's important for you to find out the particular features and requirements of any policy that your insurance salesman pitches as a hybrid annuity before you buy. That way, you stand the best chance of understanding whether it's appropriate for you in meeting your financial needs.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.