More than ever, people are concerned about the prospect of outliving their finances in retirement. In a Merrill Lynch Affluent Insights Quarterly survey conducted in December 2010, 57% of those polled were worried they would not have enough money in their later years.

As we continue to lead longer lives, that scenario has become more likely. A 2007 study by the University of Pennsylvania's Wharton Financial Institutions Center concluded that of all those people who, at retirement, calculated their income needs based on the assumption that they would live to age 85, half would eventually run out of money—because their longevity would be greater than they estimated.

"People are enjoying substantially longer retirements but face an even greater challenge of not outliving their assets, particularly in the face of rising prices," says Anil Suri, managing director, head of Investment Analytics, GWM Investment Management & Guidance. He adds that this type of "longevity risk" can be heightened when markets are volatile.

In that context, annuities can play a critical role as part of an overall retirement income strategy. The idea behind them has obvious appeal: In exchange for your lump sum or premium payments, an insurance company guarantees that you will receive periodic payments, either for a set period of time or, more often, for the rest of your life.

"With a life annuity, you can never outlive your income stream," says John Mulhall, managing director, Insurance and Annuities Product Management, for Merrill Lynch. "By annuitizing a pool of assets, you guarantee the sustainability of income payments from that asset base. You also never have to worry that market volatility will cause fluctuations in the stream of income provided by your annuity."

Annuities come in a variety of forms, many of them designed for specific needs. But they are not necessarily right for everyone. Purchasing one can require a high initial cash outlay, and owners will pay certain fees and possibly penalties. In order to determine whether annuities make sense as part of your retirement plan, it's important to know more about which ones may suit your retirement needs.

Fixed immediate annuities: Slow, steady and unchanging

Fixed immediate annuities can be thought of in these terms: In exchange for a single premium payment, you are purchasing a guaranteed stream of income that cannot be outlived. The level of income provided by fixed immediate annuities is largely dependent on your age at the time of purchase (with older clients receiving higher payouts) and the prevailing level of interest rates. The lower the prevailing rate, the lower the guaranteed payments from the annuity will be—an important factor to consider in today's environment, with interest rates currently at historic lows. Additionally, your health relative to your age should be considered: Healthy individuals who live beyond their predicted life expectancy will achieve the greatest utility from fixed immediate annuities, since they will receive income payments for a longer period of time.

It's also worth noting that you lose access to the funds used to purchase an immediate annuity—you can't tap them for a medical emergency, for example—and once you die, the income stream often stops. For all these reasons, people in good health for their age stand to benefit the most from the cumulative payouts of lifetime immediate annuities.

Another factor to keep in mind with immediate annuities is that, in periods of inflation, the purchasing power of your income will erode. BofA Merrill Lynch Global Research forecasts U.S. long-term inflation of 2.5%. Even at this moderate rate, today's dollar will be worth 61 cents in two decades—and even less if inflation rises sharply. To offset that, you might consider an annuity with a cost-of-living adjustment, but bear in mind that this feature will lower your initial payout.

To realize the benefits of a fixed immediate annuity as you mitigate its potential drawbacks, you may want to make it only a portion of your overall retirement income strategy. By doing so, you get longevity protection and regular income from the annuity while preserving the remaining portion of your assets for other purposes, such as unexpected cash flow needs or bequests.

Variable annuities: Guaranteed income with upside potential

If you want access to a guaranteed stream of income with the potential for market growth, you may want to consider variable annuities with an optional income guarantee. Variable annuities differ from fixed immediate annuities in that you retain control of the assets used to purchase the contract and can invest the contract's assets in a wide range of professionally managed investment options, also called "subaccounts."

Should the investments within your annuity perform well, your guaranteed income payments can increase. But you receive the guaranteed payout for as long as you live, even if your investments drop in value. Because of their growth potential, variable annuities are more likely than fixed annuities to keep pace with inflation over time.

All these features offer advantages to those seeking both the opportunity for growth and predictable income in retirement. But there is a flip side: The price of ownership can be higher than some other kinds of investments. Like any other insurance product, variable annuities charge various fees to cover the costs of the protection provided by the insurance company. According to Morningstar's Principia Variable Annuity database, 81% of variable annuity subaccounts have annual fees of between 2% and 3%, and some charge more than 3% to cover the costs of the insurance provided. Additionally, any optional feature you add to a variable annuity—for example, an income guarantee or a death benefit guarantee—increases the product's total cost.

Variable annuities and their tax advantages

Since a variable annuity is often also a deferred annuity—that is, it accumulates value until it pays distributions, usually during retirement—any investment gains grow tax-deferred even if you change the investments you own inside the annuity. Consequently, gains aren't taxed until you start taking money out of your variable annuity contract, just as with a 401(k) or a traditional IRA.

"Because variable annuities offer tax-deferred treatment of gains, a portfolio of investments can potentially accumulate faster than a portfolio of similar investments in a taxable account," says Mulhall. However, that benefit brings with it the potential for higher taxes on the payouts. That's because distributions of gains from an annuity are taxed as ordinary income, rather than as income generated from other sources—such as a portfolio of mutual funds, for example, where long-term gains are currently taxed at 15%.

Where annuities can help

What role should annuities play in your overall retirement income strategy, and which kinds of annuities may be suited to your situation? It depends on your age and health, how much the certainty that an annuity represents appeals to you, and the level of income you'll need in retirement compared with what you're earning now. You should also have a pretty good idea about what portion of your income you're willing to put into nonannuity investments that come with the potential for greater returns—and greater risk.

Mulhall suggests that you consider supplementing Social Security and any pension income with a guaranteed stream of income from annuities so that you can meet your month-to-month living expenses.

He sums up the attraction—and the limits—of annuities this way: "You may earn higher rates of return by keeping your assets invested in the market, but there is also a value to insuring your assets and guaranteeing that you won't outlive your assets. That's what many annuities are designed to do."