Variable Annuities: Lifelong Income, High Cost

People worried about losing their retirement savings in the stock market are seeking safety in variable annuities that promise lifelong income. U.S. insurers' sales of variable annuities jumped 24 percent in the first quarter, led by policies that offer guaranteed minimum payments. Moshe Milevsky, finance professor at the Schulich School of Business at York University in Toronto says the products appeal to investors who "fear that the S&P at 1,300 is a mirage and it's going to go back to 700 for the rest of our lives."

Sales of variable annuities in the U.S. climbed to $39.8 billion in the first quarter, from $32.2 billion the year before, according to trade group Limra. Investors withdrew $50 billion from U.S. stock mutual funds in the 12 months through April, according to Morningstar (MORN).

With variable annuities, customers can save for retirement with investments such as stock and bond funds, and their money grows tax-deferred until they withdraw it. For MetLife (MET) and Prudential Financial (PRU), the top two U.S. life insurers, the hottest product this year also offers a guarantee of income for life, even if a customer's account balance falls because of market declines. About 96 percent of Prudential's record $6.8 billion in sales of variable annuities in the first quarter included riders guaranteeing lifetime income. At MetLife, 80 percent of the $5.7 billion of products sold in the quarter carried a guaranteed benefit.

The protection comes at a cost. The annual fee for the guaranteed income rider averages about 1.03 percent of the assets in the account, according to Morningstar. That's on top of the regular annuity fees, which average about 2.51 percent. The high fees mean that "the upside potential" in these contracts is "fairly limited," says Kenneth Masters, director of life insurance design and development for Pinnacle Financial Group.

The contracts also come with so many conditions and limitations that it's difficult for consumers to understand them, and terms vary by insurer. "Say you wanted to compare five products side by side," says Tom Idzorek, global chief investment officer for Morningstar Investment Management. "Good luck."

Here's how a Prudential offering works: A customer buys a variable annuity and picks investments such as stock and bond funds offered in the contract. When the owner decides to start taking out money, his or her annual income is based on the highest value the account ever reaches, increasing at a 5 percent annual rate until withdrawals begin. That amount "is not available to cash in," says Jac Herschler, head of business strategy for Prudential's annuity division. "It's only the basis for determining what they can withdraw from their accounts every year." The limit on withdrawals for someone 59½ to 84 years old who wants to get the same amount of income annually is 5 percent.

New York Life is launching a competitive product in July that it claims is simpler, called a deferred income annuity. You pay now and select a date in the future when you want to start receiving payouts. For example, a male who buys a deferred income annuity for $100,000 at age 65 can get $17,805 a year for life starting at age 75.

An even less complicated approach is an immediate annuity. Buying one through Vanguard, a man can pay $100,000 at age 65 and get as much as $7,514 a year for as long as he lives. A drawback with immediate annuities is that buyers are turning their money over to the insurer—and generally no longer have access to it, as they would with a variable annuity. Even so, "an immediate annuity is the simplest way to get an income that you cannot outlive," says Glenn Daily, an insurance consultant in New York. "Easy to understand and easy to compare policies. No need to manage anything or make any other decisions after you buy it."

The bottom line: While lifetime income guarantees on variable annuities offer protection against investment losses, they are complicated and expensive.

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