A Guarantee? It'll Cost You - There's magic in the idea of a check for life, where the dollar amount can rise but never fall.

A Guarantee? It'll Cost You - There's magic in the idea of a check for life, where the dollar amount can rise but never fall. But now comes the question of what you'll pay for it.

By Jane Bryant Quinn
© 2006 Newsweek, Inc.
May 8, 2006 issue - I hear you're looking for investment guarantees. You want your retirement money to grow but without the risk of market loss. To make you happy, new "safety net" products are blooming like tulips in spring. But are they really worth their costs? Sometimes yes, often no. You have to understand what you're getting and what you're giving up.

Here's what your broker is probably pushing now: a variable annuity (VA) with "guaranteed minimum withdrawal benefits, for life." That's an income guarantee. You put up, say, $100,000, and invest it in the VA's stock and bond mutual funds. All your earnings grow tax-deferred. You can usually withdraw up to 5 percent of your original payment each year ($5,000, in this example) for as long as you live. If the value of your VA goes up, your annual minimum check can go up, too. If you die, the remaining value of your account goes to your heirs, not to the insurance company, as would be the case with regular lifetime annuities.

In another version, a VA may guarantee that you'll get your money back, no matter what happens to your investments, as long as you hold for at least 10 years.

Dealing first with the money-back guarantee, I asked Ibbotson's Alexa Auerbach the following question: what's the chance that a well-diversified investor will lose money over 10 years (120 months)? She tested three portfolios—all Treasury bonds, all stocks (Standard & Poor's 500 Index) and a 50-50 split between stocks and bonds—over 376 10-year periods, starting in 1965. Guess what? You never would have lost any money. Most 10-year returns were in the triple digits. So what are you paying an insurance company to guarantee? "If investors understood this, they would choose a conservative, diversified mix of mutual funds, not a VA," says financial planner J. Brian Preston of McDonough, Ga.

But how about the lifetime-income promise? There's magic in the idea of a regular check, where the basic benefit can rise but never fall. "Mutual funds give you the investment returns but not the guarantees," says John C. Walters, head of Hartford Life's U.S. Wealth Management Group.

A pensionlike income is fine. But it's far from certain that your guaranteed draw will actually rise, even if the market does. Here's why: you're taking out the fixed 5 percent you started with and paying maybe 3 percent in annual fees. For your check to grow, your investments have to earn enough to cover your withdrawal plus costs. That's unlikely if your VA contains both stocks and bonds, says annuity expert Moshe Milevsky of York University in Toronto. If the market falls, you also have to earn back those losses before you qualify for a higher draw.

What are your alternatives? If you're investing money outside a retirement account, you want straight mutual funds, not a VA. With funds, you pay low capital-gains taxes on your profits, and heirs can inherit them income-tax-free. With VAs, you're taxed at ordinary income rates. Your heirs will owe those taxes, too. (In retirement accounts, VAs and funds are taxed alike.)

Now comes the question of cost. Milevsky says that the income guarantee itself is attractively priced. Still, you're paying 2.5 percent to 3.5 percent a year (and more!) to cover high commissions and other expenses. A do-it-yourselfer in indexed mutual funds might pay as little as 0.2 percent a year. A fee-only planner might manage your money for 1.2 percent, including fund fees. That's a huge difference, over time. High costs slash your investment gains.

There's plenty of evidence that people don't understand the VAs they're buying. Product differences abound, and the mechanics are far more complicated than I've shown here. You face surrender charges if you withdraw extra money too soon (perhaps before seven years have passed). The complaints on file with regulators are running high, and the sales materials can be murky. A Hartford brochure makes the VA look richer than it is by comparing its pretax return with that of an outside investment's post-tax result. Walters had no comment, but I'm not picking on Hartford here. Other insurers do the same.

What are the alternatives if you want guarantees? For current income, you might use some of your money to buy a fixed lifetime annuity (the payout could vary with market performance, and fees are lower than on VAs). Put the rest in low-cost mutual funds for growth. Low costs mean higher future returns, hence more money to live on—"that's the real protection that people need," says New York fee-only life-insurance consultant Glenn Daily. For future income, planner Donna Skeels Cygan thinks you should go for reasonable safety rather than guarantees, with 50 to 60 percent of your money in low-cost stock funds and the rest in bonds or CDs.

If you can't live without guarantees, consider these VAs. MetLife CEO Rob Henrikson says they address "fear of the unknown." But the costs might surprise you. Think them over and take your time.

Correction: In my story "When Your Paycheck Stops" (NEWSWEEK, April 17), I understated the high cost of reverse mortgages. The lender can charge up to 2 percent of the value of your house, not just the value of your loan.

Reporter Associate: Temma Ehrenfeld