Variable annuities: Beware of shrinking payouts (pg. 2)

  @Money August 6, 2013: 5:35 PM ET

Then there are the fees. The average toll for the popular minimum withdrawal benefit rose from just under 1% in 2009 to about 1.25% as of December, says Morningstar. Add to that the hefty costs of the base VA itself and expenses end up biting off 3.7%, on average, of the account value per year, according to the latest figures.

Over time that severely crimps your portfolio's ability to grow. Even after a bear market like the one in the 2000s, $100,000 in a mutual fund portfolio of 60% large-cap stocks and 40% intermediate-term bonds (assuming 0.75% in fees) would have grown to around $131,600 in 10 years. The same investment in today's average VA rider would be worth only $95,500.

Bottom line: These changes greatly reduce the payouts possible compared with past contracts. In a bull market, you're looking at thousands less in annual income.

The cutbacks give ammunition to the product's detractors, who have long argued that high fees eroded VAs' supposed benefits. "The upside potential on these is just a marketing fantasy," says Scott Witt, a Milwaukee-area actuary and fee-only insurance adviser.

Proponents counter that the products allow investors who remain scared stiff by the markets to feel comfortable with a bigger stash of stocks. VA riders "deliver peace of mind through guarantees of lifetime income, which can be especially valuable in an uncertain economic environment," says Whit Cornman, a spokesman for the American Council of Life Insurers.

Related: How much will you need for retirement?

But even some fans say that skimpier riders have made them less likely to recommend the products. "Today's benefits are so inferior," says Scott Stolz, president of the insurance group at financial advisory firm Raymond James.

What to do if you already have a VA-rider combo

Know what you're in for: Owners with contracts written before 2011 have been most vulnerable to term revisions. Thus far the most common changes have been to restrict stock allocation or force customers into more conservative options, to raise fees on the riders, and to limit additional contributions (guarantees haven't been touched for existing policyholders).

The fine print in the contracts generally allows your insurer to make these types of revisions, though the company will be required to inform you when terms are amended.

Haven't heard anything yet? You are not necessarily in the clear, says Stolz of Raymond James: "The longer interest rates stay low, or if there is a significant drop in the stock market, the more companies will feel a need to make changes."

Evaluate your guarantee. If you're being hit with a change, you have two choices: Accept the new terms and keep the contract, or cancel and find an alternative investment.

One way to make this decision is to look at the difference between your benefit base and the account value: If the former is at least 15% higher, you should probably keep the rider, says Wheaton, Ill., financial planner Robert O'Dell.

Calculating how much income you could take right now can also help you benchmark, says Stolz.

Start by multiplying your withdrawal rate by your benefit base; for example, 5.5% of a $500,000 benefit base is $27,500 a year. Next, compute what percentage of your actual account balance that income represents. On a balance of $435,000, $27,500 represents 6.3% -- much more than the 4% initial maximum that financial planners would recommend drawing from a portfolio to sustain a long retirement.

"It's an indicator of value," Stolz says, one that would probably outweigh the effect of any higher fee or investment change.

What if you're offered cash to drop the rider? Offers can be tempting (Hartford, for example, is dangling up to 20% of the benefit base for certain accounts). But as David Blanchett, Morningstar's head of retirement research, points out, "If the insurer wants to buy your policy, taking the cash probably isn't a very good deal for you."

You're likely to have a valuable guarantee that the company doesn't want to get stuck paying.

Keeping it? Start drawing now. An analysis published in February by York University's Milevsky concluded that most owners of older rider contracts should take income sooner rather than later. Essentially, he said, at age 65 and beyond, the income from taking payments now outweighs any increase you might achieve through step-ups in your account value down the road.

Related: Can you afford to retire?

"The sooner you run down the VA and get the account to ruin, the quicker you start living off the insurance company's dime and stop paying insurance fees," his report says.

That said, if the percentage you can withdraw goes up with age and you're close to a break point -- you're 69, say, and the percentage goes from 5% to 5.5% at 70 -- wait until then.

Ditching it? Minimize your costs. Early on, variable-annuity owners are hit with a charge on the way out the door. These "surrender fees" usually decline over five to seven years -- say, from 8% the first year down to 2% in the seventh. Wait to cancel until the percentage owed falls below the annual expenses you're paying so as to avoid losing a lot of your investment value.

Also, be aware that if you own the VA outside an IRA, canceling could trigger a big tax liability: You'll owe ordinary income taxes on investment gains.

You can avoid those by exchanging the annuity for another in what's called a 1035 exchange, says financial planner O'Dell. See the next section for alternative products that can secure your income. Just make sure to get 1035 forms from the insurer.

More: What to do if you're shopping for income

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