It depends on how you're planning to use the UI designs created by this process.  If your only goal is to communicate the changes but not maintain "live" specs for these UIs then go with option 2.  It's efficient and effective.  You could also add these screenshots in a PowerPoint presentation and put the screenshot on the right side and the annotations with arrows on the left side (or next to) - almost like a storyboard.

If your goal is to create functional specs which you're planning to maintain in the future then you might want do the above plus create the new To-Be screens in a tool which allows you to easily modify them later.  For example: Dreamweaver for web-based screens, Visio for windows mockups or a visualization tool such as iRise.

Hope this helps!

- Adrian