A friend asked for my opinion about annuities during dinner Monday night. He is nearing retirement and he followed his adviser’s suggestion to move some of his savings to annuities, but was curious to hear my opinion. I responded that under the right circumstances, annuities do make sense.

An annuity is a contract to provide a stream of cash payments in exchange for a set investment. The investment can be a one-time, lump-sum amount or a series of payments to an insurance company. Depending on the type of annuity chosen, the payments either start immediately or can be deferred to some point in the future. Furthermore, the payments can be fixed or variable.

The allure of annuities are their tax advantages (investment earnings grow on a tax-deferred basis) and the certainty of cash distributions. The downsides are their costs, the loss of control over your money, the potential for the insurer to become financially unstable and the steep penalties for withdrawing money or closing the annuity early. There are also two other big downsides: the products can be complex and not all advisers selling them understand their complexity, much less are able to answer important questions about them.

If you are working with a competent adviser who is able to fully explain the contract, is forthcoming about the penalties for early withdrawal and reveals all charges and suitable alternatives, annuities can serve a useful purpose. An annuity that pays a fixed amount of cash flows or assures a minimal level of cash flow offers security. It reduces your longevity risk, the risk that you will outlive your savings. No matter what happens to the markets, as long as the insurer stays afloat, you can count on a certain amount of cash flows. This security is why some economists and retirement planners like annuities.

On Wall Street, there is always a trade-off, however. In the case of annuities, you exchange stability for future upside return. If the market does well in the future and you have a fixed annuity or one that is tied to inflation, you will not benefit from the rise in stock prices. If you hold a variable annuity tied to the performance of stock indexes, your return, by the very nature of the contract’s design, will be less than the performance of the market.

You also give up the ability to easily move your money around. Annuities can come with steep exit charges and should only be bought by those willing to make a long-term commitment to them.

While I think annuities are useful products under the right circumstances, retirees have several other options available to them. A bond ladder will also provide a stream of cash flow, but with more flexibility to withdraw funds early. (You may, however, have variability in future cash flows depending on how the ladder is constructed.) A balanced portfolio of stocks and bonds will give you both income and capital appreciation. So, when considering an annuity, think carefully about the positives, the negatives and what strategy is best for your personal situation. And make sure you are working with an adviser who truly understands the products he is selling and is willing to answer all the questions you have.

More on AAII.com

• How to Create Your Own Pension: A Closer Look at Immediate Annuities – Julie Jason explains the nuts and bolts of investing in annuities.
• The Role of Inflation-Indexed Annuities – Paula Hogan offers suggestions on how to get started with annuities, including how much to allocate to them.
• Do You Invest in Annuities? – If so, tell us on the AAII.com Discussion Boards.
• Don’t forget to take the Sentiment Survey.

The Week Ahead

Just three S&P 500 companies will report next week, as we wait for first-quarter earnings season to officially begin. Those companies are McCormick & Company (MKC) on Tuesday and ConAgra Foods (CAG) and Monsanto (MON) on Wednesday.

The week’s first economic data will be the March ISM manufacturing index, February construction spending and the March PMI manufacturing index, all scheduled for release on Monday. Tuesday will feature February factory orders. The March ISM non-manufacturing index and the March ADP Employment Report will be published on Wednesday. Friday will feature the March employment numbers—including the change in nonfarm payrolls and the unemployment rate—and February international trade.

AAII Sentiment Survey

Individual investors became both less optimistic and less pessimistic in the latest AAII Sentiment Survey. This is the first reading since last August to show both bullish and bearish sentiment below their historical averages at the same time.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 0.5 percentage points to 38.4%. This is the fourth time in five weeks that bullish sentiment is below its historical average of 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, spiked by 5.2 percentage points to 33.0%. This is just the second time since October 11, 2012, that neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 4.7 percentage points to 28.7%. This is the first time in six weeks that bearish sentiment is below its historical average of 30.5%.

It has been unusual over the past few years to see both bullish and bearish sentiment below their respective historical averages on the same week. Though this week’s readings are only modestly below their respective averages, they are indicative of the mixed thoughts individual investors have about the length of the current rally. While seeing the major indexes trade near record or multi-year highs has prompted some AAII members to be more optimistic about the short-term direction of stock prices, others fret that stocks are overbought and are due for a pullback. Also impacting sentiment are mixed views about the pace of economic growth and ongoing frustration with Washington.

This week’s special question asked AAII members what influence the European sovereign debt crisis is having on their short-term outlook for stocks. About 40% of respondents said the debt problems were either causing them to be pessimistic or at least more pessimistic than they were six months ago. Nearly 32% of respondents said the crisis was not influencing their outlook for U.S. stocks, however. A few respondents said there is no change in terms of how the ongoing crisis is impacting their short-term outlook for stocks from last year.

Here is a sampling of the responses:

• “I am concerned, but I hope it will not have a serious impact on the U.S. stock market.”
• “I’m very cautious. I don’t trust the politicians or the central bankers.”
• “The European debt crisis has been going on for some time and the longer it lasts, the less worried I become.”
• “None. Since the eurozone crisis began a couple of years ago, I sold all of my foreign holdings.”
• “Relative to last year, not much as has changed in my thinking. I was pessimistic then and nothing has changed my view now.”