Beware - Variable Annuity 5% Guaranteed Income - NOT!

The following column from consumer advocate Humberto Cruze of Tribune Newspapers was posted November 2004.

At least twice a week, I get asked about a special kind of variable annuity that many readers believe guarantees an annual return of 7%. It is, according to the National Association for Variable Annuities trade group, one of the bestselling annuities in the market today.

Judging by my reader mail, it is also the most widely misunderstood. And the people who sell it don't seem to be doing a very good job of explaining it (assuming, to think the best, they are not trying to mislead you).

In reality, the guarantee these annuities offer is that at worst you'll eventually get your principal back with no interest, and not all at once but in payments spread out over more than 14 years. The 7% refers not to any interest rate you earn (you earn zero interest) but to the maximum amount of your original principal you are allowed to withdraw each year.

This is what you say about these annuities:

"My husband and I have recently purchased an annuity at the advice of a financial adviser but are wary of directing too much of our meager savings into it," a reader wrote via e-mail. "It sounds too good to be true, a 7% guaranteed return."

Here is another e-mail:

"I'm a 73-year-old woman who takes care of her invalid 80-year-old husband. We have $112,000 earning about 2% interest in a bank account. I don't want to be a burden to my children, nor do I want to put what we have at risk. Even if we could get an income of $500 a month, together with our Social Security benefits we wouldn't run out of money.

"One possibility I've thought about is annuities. They make me nervous, although I have a friend who thinks they are the greatest. She claims her principal is always preserved and she is getting paid 7% interest. Sounds too good to be true to me."

You're right, it is too good to be true. And even though I've touched upon this topic before, it is obvious I need to discuss it again.

Suppose you put your $112,000 into this type of so-called "guaranteed minimum withdrawal benefit" annuity. It would then be invested in "subaccounts" similar to mutual funds, which could go up or down in value.

But even if the annuity value went down to zero, you could - based on the annuity guarantee - withdraw $7,840 a year (7% of the $112,000) for 14 years and the remaining $2,240 of your principal on year 15. At that point, you would run out of money.

Of course, you can do the same if you simply keep the money in the bank. With the annuity, you do have the potential for higher returns. Any gains, however, are reduced by annual annuity fees and expenses deducted from the value of your account.

In addition, you also face typically high surrender charges if you withdraw more than the guaranteed 7% amount before so many years are up.

You also cannot "carry over" withdrawals from year to year. If you don't withdraw anything the first year; for example, you cannot withdraw 14% the second year. Your friend should find out, if she does not know already, how much she'd receive if she asked for all her money back now.

Rather than a variable annuity, a series of laddered certificates of deposit may offer you an acceptable yield if interest rates continue to rise, as many economists expect.

When you build such an income ladder, you invest in CDs that mature at different times. As each CD matures, you renew it for the term offering the highest rates (usually five years).

Another option, if your goal is only to generate income and you don't care about maintaining or passing on your principal, is an immediate annuity from a top-rated insurance company.

With the typical immediate annuity, you give up access to your principal forever but in return receive an income stream for as long as you and your husband live. Based on your ages, you should receive a payout rate of at least 8%. (If you put in $50,000, for example, you would receive $4,000 a year or more until you both died.) One caution: Financial advisers strongly recommend you don't put all your money in an immediate annuity but leave some principal available for emergencies.

Humberto Cruz can be reached at AskHumberto@aol.com or c/o Tribune Media Services, 2225 Kenmore Ave., Buffalo, N.Y. 14207. Questions will be addressed through his columns, but personal replies are not possible. Thanks to Tribune and Humberto Cruz for allowing Moneybulletin to reprint this objective consumer advice.