Buying Your Own Pension

I know what you want in a retirement investment: terrific stock market gains without any risk of loss, and a steady, reliable income when you retire.

Have you entered the latest AARP Sweepstakes?

No such dreamy product exists, but there are contenders — specifically, variable annuities with what are called "living benefits." Our age group is the target market for these complex, high-cost investments. How do they work, and are they worth it?

Living-benefit variable annuities are sold by stockbrokers, insurance agents and financial planners. Typically, they're a package deal, with an investment part and a guaranteed-income part.

The investment part. You put up a lump sum, generally $50,000 or more of your retirement savings. It's invested in various stock-and-bond "subaccounts" (annuity-speak for mutual funds). These accounts rise and fall with the market, minus costs. You're hoping, of course, for excellent long-term gains. At retirement, you can make withdrawals from this account in any amount you want — a lump sum or periodic payments — just as you would from a mutual fund investment.

Don't buy on someone else's say-so. You might get trapped in a low-performing annuity with high surrender costs. — Photo illustration by C.J. Burton

The guaranteed-income part. This portion of the annuity is your safety net. The insurance company promises to credit your original investment with a fixed increase every year. Commonly, a gain of 5 percent is entered on the books, plus a higher dollar amount if your investment accounts do well. If your investments do poorly, you're still OK. The minimum guaranteed increase always applies. However, this isn't a value that you can take in a lump sum. Instead, the contract fixes a withdrawal rate that will last for life.

For example, take a $100,000 annuity with a 5 percent income guarantee. I'll assume the worst — the stock market falls and your investments are now worth only $70,000. Your guaranteed-income account, however, has still been credited with 5 percent compounded annually on the original $100,000. It's worth about $163,000 if you bought at age 55 and held it for 10 years. At 65, you can turn it into $8,150 a year for life. Like all annuities, any gains accumulate tax-deferred. You pay taxes at ordinary income rates when you take the money out. If you die, any money left in these types of annuities goes to your heirs, after taxes.

This is a barest-of-bones description of living-benefit annuities. Stiff penalties apply to early withdrawals, and different products work in different ways. If you're thinking of buying, you'll need to do a lot more research. Here, I want only to give you a few things to think about.

Next: A low-cost alternative to living-benefit annuities. »