Variable annuities - No pot of gold (cont.)

The costs ultimately constrain your income since the benefit base -- used to calculate the amount you get -- can grow only as high as your account value.

Fees and withdrawals come out of your actual account (until it runs dry, at which point the insurance kicks in). So a portfolio with a 4.5% withdrawal and average fees has to earn more than 8% a year just to stay even with the benefit base, says Minneapolis financial planner Jonathan Guyton.

"That's an awfully high bar," he adds. This doesn't even account for inflation: If your income never rises, your purchasing power will fall.

What to watch out for

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Above-average fees. You can do better. Vanguard and Ameritas charge less than the norm, in part because they don't pay commissions and in part because they offer inexpensive funds.

A Vanguard VA with a basic rider can cost as little as 1.55% a year. If you like another insurer's offerings better, you can keep expenses down by picking low-cost index funds within the VA.

High costs to cancel. Should you need to break the contract, you could pay a hefty surrender fee, as much as 9% -- which is why it's important to make sure the product is right for you before you buy.

One of the strongest allures of the VA-rider combo has been the ability to safely stash lots of money in stocks without jeopardizing future income. "For someone who is terrified of the market, the rider allows them to transfer the risk to the insurer," notes David Blanchett, investment research director at advisory firm Unified Trust.

Until 2008 many VA riders allowed stock allocations of up to 100%. When stocks nose-dived, however, this freedom left insurers on the hook for billions in payments.

Now 93% of companies restrict how much you can put in equities if you choose a rider, up from 62% in 2006, reports Morningstar. You're either stuck with prefab portfolios, or you must cap your stock portion at 60% or 70%. A few companies, including Prudential, will also transfer your money into bonds if the account value falls below a certain amount.

What's wrong with a stock-heavy mix?

Such restrictions "harm the consumer," says York University finance professor Moshe Milevsky. More balanced asset allocations are inherently less volatile, meaning they're less likely to have the kinds of losses the rider is protecting against. "So what's the point of the guarantee?" Milevsky asks.

In fact, the higher your stock allocation, the more likely a VA rider will provide more income than a low-fee mutual fund portfolio. During the awful 2000s, a VA and rider with 60% in stocks and 40% in bonds would have generated less income after 10 years than the same mix of mutual funds. Upping the stock allocation to 80%, however, gives the rider a tiny edge, with $22,000 in income, thanks to the guarantee, vs. $21,500 for the funds.

If you're paying so much to insure your portfolio against losses, you also want to make sure you have as much opportunity to benefit from the market's upside as possible. In the bull market '90s, for example, the 80/20 mix still generates less income than the 60/40 mix of mutual funds, but nearly 20% more growth than the more conservative 60/40 in the VA.

What to watch for

Too much restriction. To reap the full benefit of downside protection while getting the most out of the upside, invest as aggressively as you can -- a minimum of 70% in stocks, the highest allocation the low-cost options allow. You can be more conservative with assets outside the VA.

The rider offers certain freedoms, like the ability to withdraw more than your guarantee in a given year and the chance to leave what's left of your account value to heirs. But there's a tradeoff for those benefits.

Say a 65-year-old man puts $300,000 into a VA with a rider and starts taking income immediately. He can get 5%, or $15,000 a year.

Alternately, he could use the money to buy another insurance product called an immediate annuity, which would pay him around $21,500. Put another way, he could have gotten that same $15,000 by spending about $209,000 on an immediate annuity -- and would've had $91,000 left over. "You could take a chunk of your portfolio to Vegas and still buy more income with an immediate annuity," jokes Michigan financial planner Robert Schmansky.

With the immediate annuity, however, "you give up liquidity and flexibility," says Bennett Kleinberg, a VP at MetLife, which sells both types. You turn over the money to the insurer, which keeps the funds even if you die soon after buying; you also can't tap the account. (The immediate annuity pays more in part because the insurer transfers some of the payments from those who die before their life expectancy to those who hang on longer.)

But people tend to underestimate the costs of retaining access to their money, adds actuary Garth Bernard. Using less cash to buy an immediate annuity may actually give you more flexibility, since you can then use the balance for other needs.

What to watch out for

Sacrificing too much income. Bernard suggests evaluating a VA-rider duo in this way: "Think about how much cash you'd need to buy that same income through an immediate annuity." Check prices at immediateannuities.com, using the age at which you plan to take payments. Then ask yourself if you're willing to give up the difference.

Using the VA as a piggy bank. While you can draw more than the guaranteed percentage, doing so cuts into your benefit base, thus your future income. So if you invest in a VA, keep at least 18 to 24 months of living expenses outside it for unexpected costs.

As you've seen, a conservatively invested VA with a living benefit rider can cost you in good markets. But for those retirees who planned to start taking income just after the market bottom in 2009, the rider must have felt like a godsend.

Let's say your money had been growing for 10 years when bam! the collapse caused large-cap stocks, which made up 60% of your portfolio, to lose 37%. The $300,000 you'd invested in the VA a decade ago was now worth only $249,000. But because of the 5% roll-up on your benefit base, you'd still be guaranteed $22,600 in income, 11% more than you could buy via an immediate annuity with the equivalent mutual fund portfolio.

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Retirees who didn't have this protection fell victim to what investment gurus call an unfortunate "sequence of returns." If a period of sharp declines hits at the same time that you start drawing down your savings, it's hard for your portfolio to catch up and sustain your withdrawals. "The rider is not just insurance against a one-year catastrophe," says Milevsky. "It's insurance against a perverse sequence of returns that can affect you specifically when you retire."

So what's the likelihood the market will dive at the wrong time?

Blanchett, of Unified Trust, attempted to answer that. Using 100,000 market and life-expectancy scenarios, he evaluated a VA rider 70% in stocks against a low-cost mutual fund portfolio 50% in equities. His conclusion: Assuming a 4.5% withdrawal with the rider, and the same amount of cash from the funds, a couple taking income at 65 have a 4% chance of the rider doing better. "Markets have to perform very poorly and both spouses have to live longer than average" for the rider to be more effective, he says.

That's a small chance, though Blanchett cautions against viewing the rider purely in terms of probability. "Insurance isn't meant to pay off," he says. "The question is, How much will the rider cost relative to the possible benefits?" Those benefits include the peace of mind you may derive from knowing you have a minimum income no matter what.

What to watch out for

Sheltering more than you have to. The gap you most want to consider protecting is the difference between your estimated annual expenses and guaranteed income sources, says Peng Chen, president of Ibbotson Associates.

Divide your total savings by your funding gap to see how well you can cover the shortfall. The higher the number, the less you need a VA with a rider, a 2010 Ibbotson analysis found.

A ratio of 10 suggests putting 60% of your money into the product; at 20 times, it's more like 8%. Let's say you have $50,000 coming in from Social Security and pensions, and you're expecting yearly costs of about $70,000. If you had $200,000 saved, you might put $120,000 in a VA and rider; if your nest egg topped $400,000, only $32,000. "The more you've saved," says Chen, "the less you need to insure against outliving your money."