A discussion of annuities often leads to glazed eyes or mass migration toward the exits. However, if you own an annuity or have been given the hard sell by your broker, knowing the basics might prevent some costly mistakes.

Annuities are retirement investment plans and insurance policies combined into one package -- sort of the Swiss Army knife of retirement investments, but not nearly as useful. There is a bewildering array of annuities and add-on options available, but the principles can be quickly and painlessly grasped.

The basics
Annuities have a lot in common with other retirement plans, such as traditional IRAs, 401(k)s, 403(b)s, and Keoghs. The investments grow tax-deferred, which means no taxes are owed until the money is withdrawn. Withdrawals may begin at the age of 59 1/2 years. When the money is withdrawn, most of it is taxed as ordinary income, not as long-term capital gains.

But that's where the similarities between annuities and other retirement vehicles end -- for better and for worse. Here are the biggest differences:

  • Unlike the money you sock away in your employer-sponsored retirement plan, contributions to annuities are not tax-deductible.

  • In most situations, retirees must begin withdrawing money from their traditional IRAs and employer-sponsored accounts at age 70 1/2, whereas annuities allow withdrawals to be delayed to age 85 or later.

  • Contributions to most retirement accounts are capped at a set amount, but contributions to annuities may be any amount.

  • Annuities can guarantee income for life.

The specifics
There are all kinds of annuities, including the "immediate" annuity, which pays a stream of income immediately after a (usually large) lump sum is invested. However, this column will discuss "deferred" annuities, the kind sold as a way to save for retirement.

It all starts with the accumulation period, which begins with your first premium payment and ends when you withdraw money. Each time you send a check to the insurance company that sold you the annuity, you purchase "accumulation units." The value of those units will depend on investment returns. How are those returns calculated? That depends on whether you have a fixed annuity or a variable annuity.

Fixed annuities
A fixed-rate annuity pays a guaranteed rate of interest on your investment that may be higher than a certificate of deposit (CD) for a specified time period. Fixed annuities often offer a high come-on rate for the first year, but after that, the insurer will set the rate, with no guarantee the rate will meet or beat a CD.

Most contracts have a guaranteed minimum interest rate (often around 3%) and a guarantee of principal. But like all annuities, the fixed version comes in many flavors. There is a CD-type annuity that locks in a rate for one to 10 years. And there's a hybrid fixed annuity, as well as the equity indexed annuity, which supplements the fixed portion with additional interest based on a particular stock index (e.g., the Standard & Poor's 500). The return from the index is limited by the terms of the policy, and the "variable" portion of this annuity is small.

Variable annuities
The accumulation period for variable annuities allows money to be invested in the insurance company's "separate account" of mutual funds. Each accumulation unit's price is determined by the value of the fund divided by the number of units outstanding. Each unit represents a piece of the total worth of the portfolio. You do not own shares of the mutual funds as such.

You are purchasing professionally managed portfolios of stocks, bonds, or money market instruments and can mix and match these mutual funds. Even though the mutual fund may have the same name as a publicly traded counterpart, it is not the same investment. However, the money allocated to each mutual fund investment is subject to the same risks and potential gains as the same investment outside of an annuity. The return is variable and relies on the performance of the underlying securities. Variable annuities offer more growth, but at a higher risk. It is possible to lose principal.

The payout may be done in a variety of ways. It can be taken as a lump sum, as monthly payments for a specified period, or as a lifetime payment (annuitization). If you opt for a stream of payments, they are set up for any period of years you choose, including payments for life.

Annuitization is a heavily promoted but seldom used feature because it is inflexible: Once you choose this option, you cannot remove any lump sums of cash. If you die and a portion of your investment remains, that goes to the insurer, not your heirs, unless you choose a refund feature (which results in a lower payment). In that case, the payments may be continued to the beneficiary.

The lifetime payout option can be fixed at a certain amount per month or may be tied to the rate of return of the underlying subaccounts. The better the subaccounts perform, the higher the monthly payout. Of course, if they underperform, the monthly payments decrease.

Payout also comes in the form of a death benefit. The death benefit goes to the beneficiary you designate if you have not yet started taking payouts. A fixed annuity will often distribute all premiums paid minus any sum that has been withdrawn. A variable annuity will pay the value in the account at death, unless you have paid extra for a bonus that protects the account from loss.

If you annuitize, a schedule is set up that taxes part of each payment as ordinary income, but allows a portion of the payout to be taken as a return of the initial investment (untaxed since it was taxed before entry into the annuity).

The dark side of annuities
At first glance, annuities have a lot going for them. Hey, who wouldn't like tax-deferred growth and guaranteed income for life? But, as they say, nothing in life is free -- and that's especially true in the world of financial services.

The cost of owning an annuity is its biggest drawback. Here are the main culprits:

  • Surrender charges: This is essentially a back-end sales load that is levied against amounts withdrawn up to seven to 10 years after the initial purchase. The charge is a percentage of assets, and decreases yearly until it reaches zero. This makes the assets in your account extremely illiquid. Of course, any money earmarked for retirement should stay put. But if you're stuck in a bad annuity and wish to move elsewhere, you might pay the surrender charge.

  • The mortality and expense risk charge (M&E): This is a percentage charge against the value of the subaccounts in your annuity and is usually in the neighborhood of 1.25% of your portfolio value. This charge compensates the company for insurance risks it assumes under the annuity contract.

  • Administrative fees: An insurer will charge you to cover record-keeping and other administrative expenses. It is often a flat fee that is paid yearly. The fee is around $30 or 2% of the account, whichever is less.

  • Investment management fees: You will be indirectly paying the fees of the mutual funds that are held in the annuity. As with the expense ratio on regular mutual funds, this fee runs 1.5% a year on average.

Add it all together, and you could be paying 3% a year for the privilege of owning an annuity. There are definitely lower-cost -- and thus, probably higher-return -- options for your retirement money.

And after all this
If you still want to buy an annuity, buy one with low costs and good investment options. Also, there are annuities on which you don't have to pay a commission -- as a front-end sales charge or a back-end surrender charge. Start with the products offered by mutual fund companies like Vanguard (average total expenses of 0.67%, including mortality and expense risk charges) and T. Rowe Price (NASDAQ:TROW) (0.76% average mutual fund expenses, plus an additional 0.55% mortality and expense charge).

If you are unlucky enough to own an ugly, high-fee annuity, explore the 1035 exchange. Section 1035 of the U.S. tax code allows the tax-free exchange of your annuity contract for a new annuity contract. There may be surrender charges on the old annuity, so look carefully before you leap. And a new surrender charge period generally begins on the new annuity.

The Foolish bottom line
Annuities have some attractive characteristics, but they come at a price -- usually a price too high to pay. Inflexibility and high management fees make them much less attractive retirement vehicles than 401(k)s, 403(b)s, IRAs, and Keoghs. Do yourself a favor and fully fund these before considering a deferred annuity.

Fool contributor J. Graham owns none of the annuities discussed and can be reached by email . The Motley Fool has a disclosure policy.