by Archie M. Richards, Jr.
October 15, 2007

Variable annuities are costly. But their guarantees against substantial stock market losses make them suitable for people, scared of stocks, who keep their money in certificates of deposit.

Both fixed and variable annuities are investment vehicles whose earnings are not currently taxable. Fixed annuities are invested by the insurance company in bonds, with no guarantees. Variable annuities are invested at the policyholder's option in mutual funds of stocks, with the insurance company guaranteeing against substantial losses. (See the column "If You Won't Buy Stocks Without a Guarantee, Here's a Solution" dated 5/19/03 for a generic description.)

Variable annuities have the following problems:

• When earnings are withdrawn from the policy, they're taxed as ordinary income, not capital gains. The variable annuity converts low-taxed long-term capital gains into high-taxed ordinary income.

• Unlike regular investments, the policy value does not attain a new tax basis at death. The profits are taxed even after you die.

• Like an IRA, withdrawals before age 59½ can be subject to a 10-percent, non-deductible penalty tax.

I reviewed the prospectus and other written materials of a prominent variable annuity. To avoid implying that this policy is better or worse than others, I omit the company's name.

The policy offers a multitude of features. Once mentioned in the prospectus, a feature is generally referred thereafter by its initials, making the prospectus laborious to follow. But most people don't read the prospectus. They obtain their information from the salesman/advisor, which is sometimes an advantage and sometimes not.

The policy's main features and costs are as follows:

• The policyholder can select the investments from among 69 mutual funds. The costs vary, but the ones I would choose tend to be on the low side. We'll assume 1 percent of the policy's value every year.

• The basic charge for the annuity is 1.05 percent a year (0.85 for annuities held inside IRAs). This charge guarantees that, at death, your estate would receive the current policy values or the initial investment, whichever's higher.

• You can withdraw up to 10 percent a year without a redemption charge. Beyond this, a hefty but declining redemption charge is incurred within a certain number of years.

Here are some of the optional features:

• One takes effect during the policyholder's life. It provides that, as long as you hold the policy for at least 10 years, you retain 80 percent of the account's "high-water" mark attained during the 10-year period. For example, if the value attains a new high in 2008 and you withdraw in 2010 when the value is down significantly, you can nevertheless remove 80 percent of the higher 2008 value. The cost of this feature is .65 percent of the policy's value each year.

• You can also acquire a guarantee that would take effect at death. Say the policy establishes a high-water mark during a year. If you die in a subsequent year, when the values are down, the beneficiaries receive 100 percent of the high-water mark. This guarantee costs 0.25 percent a year - a good deal for a person who's otherwise uninsurable.

These guarantees, I must say, are inexpensive. In the investment industry, reasonably-priced guarantees against loss in the form of derivatives would be more costly.

Policyholders can acquire both the living and the death benefits. But people generally acquire one or the other.

Assume you purchase the living benefit for .65 percent a year. When you add the basic 1.05 percent annuity cost and the 1 percent investment costs, the total comes to 2.7 percent a year. The U.S. stock market has risen at 10.6 percent a year over the last 80 years. About one quarter of this would be paid in costs - a hefty chunk.

But for someone who requires guarantees, it's not a bad deal. A person who holds only certificates of deposit will enjoy a far better return from a variable annuity such as this one.

Stock-holding readers of this column, however, should probably avoid a variable annuity. They can do better without.