In this report
Anatomy of a variable annuity

Do annuities make sense for you?

You may be drawn to the guaranteed income feature, but there are cheaper alternatives

Last reviewed: December 2009

Variable annuities have long had a tarnished reputation among personal-finance experts because of the aggressive sales tactics, exorbitant fees, and confusing terms associated with them. But certain types of annuities held up well in the recent market downturn and now rank among the best investments over the past decade. Even academic studies have been kinder to them, showing that annuities might be a good option for some people. But a closer look reveals that variable annuities are still only appropriate in the rarest of cases.

An annuity is basically insurance that you won't outlive your money. You make payments to an insurer or financial services company, either over time or in a lump sum, and eventually get a monthly check. Annuities come in two major types—fixed and variable—but there are many permutations of each. Generally, with a fixed deferred annuity, you make payments over a long period of time in return for a set monthly payment in retirement. With a deferred variable annuity, you essentially pay into a mutual fund portfolio that grows tax-deferred until you start taking monthly payments. Immediate annuities, either fixed or variable, are funded with a lump sum and pay out benefits right away.

Costly features

Variable annuities let you select a mix of stock and bond mutual funds. The reason some did well as the market swooned last year was that their owners purchased a feature called guaranteed lifetime income benefit (GLIB), a relatively new option. This allowed them to receive a minimum return per year, say 5 percent, regardless of how the stock market did. But a GLIB is most beneficial when the market stays mired in a protracted period of losses.

Of course, the guaranteed income benefit costs extra. And the average annual expenses for variable annuities are already 2.38 percent according to Morningstar, compared with 1.32 percent for the average mutual fund. Those high fees are one reason variable annuities without a GLIB have underperformed mutual funds over the past 10 years. What's more, each feature you add to a variable annuity—such as inflation protection or a death benefit for heirs—adds 0.5 percent to 2 percent, so you could easily end up paying 4 percent a year or more in fees.

Variable annuities may also come with steep sales commissions and surrender charges if you take withdrawals during the first six to 10 years after you first deposit money. But some companies will allow withdrawals of up to 15 percent a year without surrender fees.

Protection for less

A simpler variety is the immediate annuity. You pay a lump sum of money, decide which features you want, and the annuity issuer will provide a set monthly payment for a specified period of time, or for life. If you choose optional features, your monthly payout will be lower. Immediate annuities often don't have a built-in death benefit like some variable ones do, so if you should buy a policy and then get hit by a bus a week later, the money you deposited will be lost. Adding on some sort of death benefit is wise, depending on its cost.

Variable annuities with lifetime income benefits are much like mutual funds with an option to convert into an immediate annuity and get a better market price added on. So if you're comfortable making your own investment decisions but want a guaranteed income, you might be better off augmenting your fund portfolio with an immediate annuity, rather than using a variable annuity for both the income guarantee and the market exposure. The downside protection is cheaper—getting the same minimum monthly payment could cost 40 percent less with an immediate annuity. In that case, your outside investments will provide the upside potential.

There's no point in considering a variable annuity if you haven't fully funded your 401(k) or IRA for the year. And if you have a stable defined-benefit pension (particularly a state or federal one), there may be no reason to buy any type of annuity.

Variable annuities are best for people who have a very high income and have maxed out their retirement accounts. They may also work for self-employed people without retirement accounts who have many years until retirement, so they can make use of the tax deferral. Unfortunately, most variable annuities are so complex that comparison shopping is all but impossible. If you want one, look at low-cost options from companies with a strong lineup of mutual funds, such as Fidelity, Schwab, Vanguard, and T. Rowe Price.

If you do decide to purchase a variable annuity, buy one with a GLIB. Even so, keep the variable annuity purchase to no more than one-third of your total assets, including Social Security and any pensions, says Moshe Milevsky, a retirement expert and associate professor of finance at York University in Toronto.

You may also want to keep an eye on mutual funds that offer similar benefits, such as managed payout funds. They require a large investment ($25,000 for Vanguard's fund) and provide a monthly payout. They're relatively new, so they don't have a proven track record, and some had to cut payouts during the market downturn last year. New issues from Vanguard and PIMCO may be worth checking out once they've become more established. But be aware that managed payout funds don't offer longevity insurance, which immediate annuities do with their lifetime payouts.

Points to consider

Here are some other factors to consider before you buy an annuity:

  • Interest rates are very low now, and should they rise suddenly you might find that your monthly payment from an immediate annuity isn't keeping pace with increased living costs. You could consider "laddering" several fixed immediate annuities, much like people do with CDs, by dividing up your money into smaller amounts and buying an annuity each year to take advantage of rising interest rates when they come back. An easier way to protect yourself is to add a cost-of-living provision to your contract, but that will probably result in a lower initial payment.
  • Since annuities are long-term commitments, make sure that the company you choose is financially stable. Several large ratings agencies like Moody's, Standard & Poor's, Fitch, and evaluate the fiscal health of insurers. (We've found to be the most impartial.) See how your company rates, then check state guarantee associations, which provide protection if an insurer goes under. In most states, annuities are insured for up to $100,000, though some states may go as high as $500,000. If you have a lot to invest you might want to spread your money across several companies, since the process for getting your account value honored should your insurer fail can be complex.
  • Married couples have to decide which spouse will own the annuity. Women tend to live longer, so they get lower monthly payments from immediate annuities.
  • Be alert for changing terms. The market downturn has hurt insurers, resulting in fee hikes and lower benefits in variable annuities. Some have dropped certain guaranteed minimum benefits—the very feature that helped give consumers positive returns over the past year.

This article appeared in Consumer Reports Money Adviser.

Posted: November 2009—Consumer Reports Money Adviser issue: December 2009