How do annuities work?

(Money Magazine) -- Question: About five years ago, my wife and I put $200,000 into an annuity. Even with the down markets, my financial adviser tells me my guaranteed step-up value is now $375,000. I'm obviously pleased but how does this work? -- Greg M., Mission Viejo, Calif.

Answer: Your question highlights one of the problems I have with many types of annuities -- namely, they can be so complicated that the people who buy them often don't understand how they work and what their investment is actually worth.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

Ultimate Guide to Retirement

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• 401(k)s & company plans
• Investing
• Annuities
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• Social Security
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Let's start with that $375,000 you cite. I'm not saying it's wrong. But it does sound awfully high. So at the very least you have to wonder how aggressively your money's been invested to reach that value within five years.

You should also know even if your "guaranteed step-up value" is indeed $375,000, that doesn't necessarily mean that you have $375,000 in your annuity that you can actually get your hands on.

I understand that at this point, nothing I've said probably makes much sense. So let me explain.

You don't specify exactly what kind of annuity you own, but it sounds as if it's a variable annuity with a guaranteed lifetime withdrawal benefit. This type of annuity -- affectionately referred to in annuity circles as a VA with GLWB -- is popular with annuity sales people as it frequently allows them to tout both guaranteed returns (of a sort) and guaranteed income for life (with some conditions attached).

Among many others, one of the things you need to know about this type of annuity is that it typically has two types of balances running simultaneously: your account value and another balance known as the income base or benefit base.

Your account value, also sometimes called the contract value, represents the amount of money actually available to you at any given time (although that amount could be reduced by surrender charges that usually start at 7% or 8% in variable annuities, but could go much higher). This balance is determined by the performance of the investments, also known as subaccounts, within the annuity.

So, for example, if you invested $200,000 and the subaccounts in your annuity lost 10% that first year, your account value after one year would be $180,000.

The income base, or benefit base, is really more a hypothetical account. It represents the amount that determines how much annual guaranteed income you can draw from the annuity. You will sometimes see variable annuities touting a guaranteed return, which typically varies from 5% to just over 7% a year. But these guaranteed returns almost always apply only to the income base, not your actual account value.

So, for example, if you invest $200,000 in a variable annuity with GLWB that guarantees a 5% annual return (sometimes referred to as a 5% "roll-up"), at the end of the first year your income base would be $210,000.

If you wanted to start drawing income from your annuity and your annuity guaranteed that you could draw, say, 4% of the income base each year for life, you would be assured of getting at least $8,400 a year as long as you live (although the guaranteed amount would drop if you pulled out more than the guaranteed draw in a given year).

There's a twist, though. Typically, the insurer will periodically compare your actual account value to the income base. This is often done on the contract anniversary date. If your account value is higher, then the insurer "steps up" the benefit base to equal the account value.

That wouldn't happen in the example above since the account value of $180,000 is less than the $210,000 income base. But if the investments within your annuity gained 10% instead of losing 10%, then your account value would be $220,000 and your income base would be reset to $220,000. Assuming a 4% guaranteed withdrawal rate, you would then be assured of being able to draw at least $8,800 a year from the annuity, instead of $8,400.

What annuity owners need to understand, however, is that the income base is used only to calculate how much guaranteed income you can draw from the annuity. It isn't a sum you can cash out. The only balance you can actually get your hands on -- that is, withdraw if you need it -- is your account value (and even then surrender charges could apply).

So, for example, if you wanted to cash out of your annuity and your benefit base was $210,000 and your account value was $180,000, you could take out only the $180,000 minus surrender charges, if any.

Since you describe the $375,000 as the "guaranteed step-up value," it sounds to me as if this amount is your income base, or the sum that will be used to calculate how much annual income you are guaranteed.

The amount you can withdraw (subject to possible surrender charges) is your account value, which could be higher or lower than your income base. You don't mention what your account value is, possibly because you're not even aware that there are two different balances.

Which brings us back to my earlier assertion that the $375,000 value you cite strikes me as high. Here's why I say that: For $200,000 invested five years ago to grow to $375,000, it would have to increase by nearly 88%. That's the equivalent of an annualized 13.4% over five years.

I don't know of any annuity that guarantees that kind of return. Which means that the only other way that your account value or income base could have climbed to $375,000 would be for the investments within your annuity to have increased in value by $175,000 at some point within the past five years. I say "within the past five years" because, given the way most step-up features work, it's theoretically possible that a spike in the account value at some time during the last five years could have triggered a step-up in the benefit base.

Given how most investments have performed in recent years, it's hard to imagine how your annuity could have racked up that kind of growth if it were invested in a truly diversified portfolio. It would have to be (or have been) concentrated largely, if not entirely, in some asset class that had phenomenal gains in recent years, say, emerging market stock funds.

I suggest you sit down with the person who sold you this annuity and have him or her explain what that $375,000 value represents and how it came to be. So you have a better idea of how annuities work before having that conversation, you might want to check out theAnnuities section in our Ultimate Guide to Retirement.

Other questions you might ask: What, exactly, is the annuity invested in -- and why? If the idea is to eventually draw income from it, when can you start doing that and how much can you pull out? What happens if you withdraw more than the annual guaranteed amount? What happens if you want to withdraw all your money -- or do a tax-free exchange to another annuity? How much would be available, and would you be hit with any surrender charges?

And don't forget to find out how much you're paying in total fees for this investment. Advisers often note that with this type of annuity, your guaranteed income can rise. That can happen if, despite withdrawals, the account value still grows, initiating a step-up in the income base.

But for that to occur, not only must your account value's return offset the amount you're withdrawing, it's got to do so after fees are deducted from your account value.

That can be a tall order considering that, aside from surrender charges, variable annuities can have three layers of fees. Combined, those charges can sometimes total upwards of 3% a year, making it difficult for your account value to gain ground after expenses and withdrawals.

At the very least, you should know what you're paying for this investment. Anyone else who owns or is considering buying this type of annuity -- or any annuity, for that matter -- should also ask these sorts of questions. If you don't get clear answers, then you might want to consult another adviser, preferably one whose primary business isn't selling annuities.

Unless you understand how an investment actually works, I don't see how you can tell if it fits into your investing or retirement strategy. And if you're not sure of that, then it's also hard to tell just how pleased you ought to be.