Guaranteed income, but at what cost?

Variable annuities may look like a surefire bet, but make sure you read between the lines before you invest.

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By Walter Updegrave, Money Magazine senior editor

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)

NEW YORK (Money) -- Question: Most of our savings are in mutual funds, including our IRAs. We were recently approached by an adviser who wants us to roll our money into variable annuities in order to prevent further declines in the value of our portfolio. Is this a wise thing to do? --Jerry, Grants Pass, Oregon

Answer: My antennae automatically go up whenever someone tells me an adviser has recommended moving his money into variable annuities. So I'm glad to see you're not just blithely following this suggestion.

It's not that I don't think that annuities in general -- or variable annuities in particular -- can play a role in retirement planning. They can under certain circumstances. But I think that role should be part of a comprehensive strategy to assure a guaranteed income in retirement, as I outlined in "How to make your money last", a story that's part of the "Four steps to a better retirement" cover package in the current issue of Money Magazine.

But even then you shouldn't be putting anywhere near all your money into an annuity, variable or otherwise.

Alarm bells also begin going off whenever I hear that someone is buying a variable annuity to protect his savings from market declines. I know that variable annuities are often marketed on the basis of various guarantees that appear to offer all sorts of security. But after hearing from many annuity buyers over the years, I can tell you that many didn't really understand the guarantee, or even know what they were paying for it.

Probably the most frequently misunderstood guarantee in variable annuities these days is a "living benefits" rider known as the GLWB, or guaranteed lifetime withdrawal benefit. Here's how it works:

Let say you're 65 and invest $100,000 in a variable annuity with this rider. Typically, the insurer will guarantee you a minimum annual income of 5% of the amount you invest, or $5,000 a year, for the rest of your life. Even if a market decline later knocks down the market value of your account to, say, $50,000, you would still be assured $5,000 annually as long as you live.

In addition to this downside protection for your income, you also have the possibility of higher guaranteed annuity payments in the future. If on the contract anniversary date the market value of your account has climbed to, say, $200,000 due to investment gains, then you would be able to apply the 5% withdrawal percentage to that higher figure, increasing your guaranteed yearly income to $10,000 for life. You would then be assured of getting that ten grand for life, even if the market value of your account declines to, say, $50,000 because of a market setback.

What's the catch?

It's important to understand that only your annual income is being guaranteed, not your actual account balance. So if you wanted to cash out of the annuity in the scenario immediately above, you would have access not to the $200,000 value on which your annual income is being calculated (which, in annuity circles is known as the benefit base or income base), but your actual account value, or $50,000 in this case.

And if later in life a combination of guaranteed withdrawals from your account and subpar market performance were to reduce your account's market value to zero, you would still be able to draw your $10,000 a year, but that you would be it. You would have no other account value to tap.

In short, this guarantee doesn't provide you with downside protection for your assets, only your income from those assets.

And even that protection has conditions you need to be aware of. For example, if you decide to draw more than the guaranteed payout amount in any year -- more than $10,000 in the case above -- the guaranteed amount can drop significantly for the rest of your life.

Other guarantees and riders that come with many variable annuities are also often misunderstood. Some annuities tout annual guaranteed growth rates of, say, 5% to 7% a year. But that percentage is typically applied to a hypothetical account value that you can "annuitize" (i.e., turn into a series of guaranteed payments) or from which you can draw a certain percentage each year.

Meanwhile, your actual account value is based on the performance of the investments you choose within the variable annuity, not the guaranteed growth rates. So if a stock market meltdown reduces the actual market value of your variable annuity by half and you want to withdraw your money, you get the market value of your annuity, not the value of the hypothetical account that's been receiving the guaranteed return.

Finally, you also need to realize what you're paying for the guarantee. The spike in market volatility over the past year has doubled, and in some cases even tripled, insurers' hedging costs of providing various guarantees. As a result, insurance companies have begun, to borrow their lingo, "de-risking," or reducing their exposure to these ballooning expenses.

One result is that the annual fee of 0.65% to 0.9% many insurers were previously charging for riders like the guaranteed lifetime withdrawal benefit before last year has now climbed to 1% to 1.25%. Throw in an annuity's other fees -- perhaps 1.25% a year for insurance costs and 1% or so for managing the annuity's investment portfolios -- and total annual costs can easily hit or exceed 3% a year. At that level, it becomes difficult for your account value to pay out income, absorb the fees and still grow so that your income can rise to keep pace with inflation.

At the very least, I recommend that you check out the annuities section of our Ultimate Guide To Retirement. That will give a better understanding of how annuities work. Given how complicated some annuities can be, you may also want to enlist the help of an adviser who doesn't have a commission riding on this transaction.

Whatever do you, though, don't move any of your money into a variable annuity without first finding out exactly what the guarantee is, what it costs and how much you'll be paying in total fees for the annuity, including surrender charges if you want to get out.

Once you've looked at it more closely, I think you'll find that this annuity isn't protecting the actual market value of your portfolio from market declines, and that you're paying a hefty price for whatever guarantee it is offering. To top of page

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