Variable annuities: Buyer beware

(MONEY Magazine) -- Chances are, you've already heard the pitch from an insurance agent or a financial adviser. And if you've been feeling anxious about the stock market (who hasn't?), it probably sounded pretty compelling: "Invest in stocks while protecting yourself from another 2008, with a guaranteed minimum return that provides income for the rest of your life!"

This promise propelled sales of variable annuities to $120 billion in the first nine months of 2011, already the highest yearly since 2007. The annuity itself -- a tax-deferred investment account with an insurance wrapper that provides a death benefit -- is only part of the appeal.

What's heating up the market is an optional feature allowing you to draw a minimum income each year until you die, no matter how poorly the market performs. This add-on, called a living benefit rider, also lets you access your account value if you need more money, and leave what's left to your heirs when you pass on.

Insurers have offered the riders for years, but since the 2008 crash, the combination of a shot at stock gains along with a safety net against losses has proved particularly potent. Today nearly nine of 10 variable annuity (VA) buyers elect some form of living benefit rider, research firm LIMRA reports.

The question is, Do they really know what they're buying? Insurers tweak their offerings constantly, and the promises are harder to untangle at every iteration.

What is an annuity?

"The riders have made a complex product more complex," says John Cronin, securities director for Vermont and head of a national regulatory group on VAs. What may be obscured in the fine print -- of which there is a dizzying amount -- is the fact that the VA-rider combo has been growing more costly and less generous.

The product's detractors in the financial planning community argue that there are cheaper ways to achieve similar results, and MONEY generally agrees.

Still, it's hard not to be tempted by the promise of security, especially in insecure times. So if you feel persuaded by the pitch, make sure you know what you're getting into -- and what you're giving up -- before incorporating a VA and rider into your retirement plan.

The guarantees are getting less rich

Living benefit riders make two key promises: You'll earn a minimum return to build your income, and you can withdraw a set percentage each year when you're ready. Before 2008, insurers were competing to be the most generous on both counts. "It truly was an arms race," says Frank O'Connor, insurance division director at Morningstar.

Is a pension a stand-in for bonds?

After the crash, however, the market value of investors' holdings fell, and the bonds insurers owned began producing less income. Consequently, the insurance companies dramatically scaled back their promises.

"Some were providing overly generous benefits and simply not charging enough for that," says Greg Salsbury, an executive at Jackson National, the third-largest seller of variable annuities. A few companies, namely Genworth (GNW, Fortune 500) and Sun Life (SLF), got out of the game altogether in 2011.

To grasp the effects of shrinking guarantees, you first must understand how the accounts work.

Within the VA, which you can buy into all at once or over a period of years, you choose how your money is invested among a selection of mutual funds. The account balance fluctuates with the market value of your holdings.

Meanwhile, a virtual account -- the "benefit base" -- grows at the minimum return. If the market does well and your real portfolio exceeds the benefit base, the value of the virtual account is stepped up to match. You might let that benefit base build for 10 or so years before drawing down. Once you do start taking income, the preset withdrawal rate is applied to the benefit base.

Insurers used to guarantee minimum annual returns of 6% or more on the benefit base. Today the typical roll-up rate, as it's called, is 5%.

Some insurers will dial back even more once you start drawing income, while others link their rate to a benchmark like the 10-year Treasury yield, causing the "guarantee" to fluctuate. Withdrawal rates have come down too. In late 2006, nearly 70% of insurers guaranteed a flat 5%; now only 21% do, reports Morningstar. Most of the rest switched to a sliding scale that rises depending on the age you start drawing -- say, from 4.5% at 59 to 6.5% at 80-plus. Couples may have to settle for an even lower rate.

What look like minor differences can have a big impact on your income, especially in down markets. If you and your spouse had put $300,000 in a VA with a rider offering a 6% return and 5% withdrawal in late 2000, you'd now be getting at least $26,900 a year. Today's 5% roll-up and 4.5% withdrawal for couples, in contrast, provides just $22,000.

What to watch out for

Too-good-to-be-true guarantees. Anything above the standard roll-up of 5% and withdrawal rate of 5% for singles or 4.5% for couples comes with either a higher cost or specific conditions today, says Tamiko Toland, editor of Annuity Insight. For example, you might get a higher rate now, but no guaranteed growth after 10 years. Be sure to read the fine print.

Higher fees get in the way of growth

Variable annuities are expensive to start with, which is why MONEY has been reluctant to recommend them.

Insurers charge a variety of administrative fees to cover their guarantees as well as hefty sales commissions. (Agents collect about 5% of the investment plus 0.5% a year.)

In addition, mutual funds within a typical VA carry expenses of about 1%. The rider, commonly called a guaranteed lifetime withdrawal benefit (GLWB), duns you too, and more than ever. It now adds 1.12% a year, nearly a third more than in 2009, Morningstar reports. All told, fees skim 3.61% off the annual returns of the average VA with a rider.

Over time those charges severely impede the growth of your account value. After a wild bull market like the 1990s, $300,000 in a mutual fund portfolio of 60% large-cap stocks and 40% intermediate-term bonds --assuming low but not rock-bottom fund fees of 0.75% -- would be worth over $1 million. The same investment in the average VA with a rider would have grown to only $783,000.

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