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Buying Your Own Pension

Annuities with guaranteed benefits are complex and costly

Man sailing waters in small boat made out of money

Photo illustration by C.J. Burton

Don't buy on someone else's say-so. You might get trapped in a low-performing annuity with high surrender costs.

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.

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.

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.

For new purchasers. Annual expenses might exceed 3.5 percent per year (more, if you include a spouse), reports Kevin Loffredi, a vice president of Morningstar. Smart buyers aim for high long-term gains by loading up their investment accounts with stocks. If you guessed wrong, you can always fall back on your minimum income guarantee. Since the 2008 financial crisis, however, insurers have limited the percentage you can invest in stocks. You have to hold more bonds, whose returns aren't worth the high fees you pay.

New buyers should look for products that still let you put up to 80 percent in stocks, says Moshe Milevsky, author of The 7 Most Important Equations for Your Retirement. Also, look for low fees — 3 percent or less. You'll find especially low fees at the Vanguard Group or Fidelity Investments.

For people holding older living-benefit annuities whose investment account has plunged. "Don't wait for the value to recover," Milevsky says. "Start your guaranteed-income payout right away." In most cases, the payment stream is worth more today than it will be if you wait a few years.

For people who don't understand exactly how the product works. Don't buy on someone else's say-so. You might get trapped in a low-performing annuity with high surrender costs. In February, a California insurance agent drew a 90-day jail sentence for selling an annuity to an 83-year-old woman with dementia. (Her boyfriend advised her on the purchase. He and his daughter were the beneficiaries.)

For a low-cost alternative to living-benefit annuities. Consider putting part of your long-term money into a "deferred-income" annuity with guaranteed payments starting at some point in the future. For growth and inflation protection, put the rest of your money into your own choice of low-cost U.S. and international stock mutual funds.

If you prefer a one-stop package deal, however, living-benefit annuities can be a reasonable, although an expensive, choice.

Jane Bryant Quinn, a personal finance expert, wrote Making the Most of Your Money NOW.