Using a Variable Annuity to Increase Your Retirement Income

This post continues my series about using IRAs, 401k plans, and other retirement savings to generate a lifetime monthly paycheck. I've previously written about immediate annuities as one way to generate this retirement paycheck, and I've also explored inflation-indexed annuities as one interesting variation that can increase your security. Here I'll discuss another variation on an immediate annuity that deserves your attention: the variable immediate annuity.

Like its big brother, the fixed immediate annuity, the variable immediate annuity provides a monthly retirement income for the rest of your life, no matter how long you live. Many retirees, however, are reluctant to buy a fixed immediate annuity because then you're locked into a specific investment for a lifetime with no upside potential and no ability to change your mind later and invest differently. There's also generally no increase to offset the impact of inflation.

Another "con" of fixed immediate annuities is the price, which changes constantly based on current interest rates. As of press time, interest rates were low, which makes fixed immediate annuities expensive. Why? The higher the interest earnings that the insurance company can make on your purchase price, the lower the annuity price, and vice versa. This is one important reason that people are currently avoiding fixed annuities.

Another reason that fixed annuities aren't cheap is that insurance companies make their guarantees over long periods -- 20, 30, or 40 years into the future. Because there's a significant risk that future interest rates will remain low, insurance companies build sufficient margins into their pricing to make sure they can meet their promises.

Variable Immediate Annuities Address All These Concerns
The variable immediate annuity doesn't guarantee any investment return; the recipient assumes both the risk and the reward of the investments. As a result, there's no need for insurance companies to build in margins for interest return guarantees, so pricing can be reduced.

Pricing is also independent of current interest rates; it's based solely on longevity and expense expectations. Because these factors typically don't change frequently, pricing of variable immediate annuities is quite stable.

Variable immediate annuities do not lock individuals into a specific investment. Depending on the administrative capabilities of the financial institution, investments can be changed at almost any time. There's generally a wide variety of investment options available, ranging from high-quality fixed income funds to aggressive equity funds.

But variable immediate annuities suffer a bad reputation, and for good reasons. Many have high expense loads and mediocre returns. There are, however, currently a few products that stand out from the crowd. For example, The Vanguard Group offers a variable immediate annuity through an arrangement with American General Life Insurance Company. The arrangement uses low expense Vanguard funds and has relatively favorable pricing. And you can choose among a variety of Vanguard funds, with various mixes between stocks, bonds and cash investments.

Looking Under the Hood
To understand how a variable immediate annuity actually works, let's take a look at the pricing. Suppose you're a 65 year-old single man who plans to use $100,000 of your retirement savings to purchase an annuity. Let's look at how much annual retirement income you'd get with Vanguard's variable annuity, compared to what you'd get from a fixed annuity, as well as an inflation-adjusted annuity, offered by Vanguard's Annuity Access program through Income Solutions. As of December 2, 2010, here are initial annual payout amounts:

$7,380 for a variable annuity, which works out to be a payout rate of 7.4 percent
$7,276 for a fixed annuity -- the payout rate is 7.3 percent
$5,194 for an inflation-adjusted annuity -- the payout rate is 5.2 percent

If you're a 65 year-old woman, based on the same information, here are the annual payout amounts:

$6,729 for a variable annuity, which works out to be a payout rate of 6.7 percent
$6,642 for a fixed annuity -- the payout rate is 6.6 percent
$4,606 for an inflation-adjusted annuity- the payout rate is 4.6 percent

If you're part of a married couple, both age 65, then here are the annual payout amounts for a 100 percent joint and survivor annuity (this annuity continues payments as long as either one of you is alive):

$5,970 for a variable annuity, which works out to be a payout rate of 6 percent
$6,030 for a fixed annuity -- the payout rate is 6 percent
$4,059 for an inflation-adjusted annuity - the payout rate is 4.1 percent

With the Vanguard variable annuity, your monthly income is adjusted each month for investment returns during the previous month. To the extent the underlying funds exceed or fall below the annualized "hurdle rate" of 3.5 percent plus a 0.52 percent load for mortality and other expenses, your monthly income is adjusted accordingly.

So your retirement income with the variable annuity starts out very close to the immediate fixed annuity, but to the extent you achieve investment returns over your lifetime that exceed the total 4% hurdle rate, you'll soon have a higher monthly payment. With most portfolios that are balanced between stocks and bonds, it's reasonable to expect that you'd exceed a four-percent rate of return over your lifetime. So compared to a fixed annuity, with a variable annuity you have the expectation that future payments will increase due to favorable investment returns. But the downside is the possibility that payments will decrease due to unfavorable investment returns.

When shopping for a variable immediate annuity, focus on the usual items that you'd look at when shopping for mutual funds: low expenses and a good investment track record for the underlying investment funds. One other variable is very important, and that's the add-on charge to the hurdle rate for mortality and other charges. Vanguard's product uses 52 basis points, but many other variable annuities use 100 basis points or more. These basis point charges offset the investment returns that are used to adjust future benefit payments, so the lower these charges are, the more income you'll receive. Fidelity Investments also offers variable immediate annuities using their mutual funds, and the mortality and expense charges are a low 60 basis points.

As usual, there are important considerations to constructing an annuity income portfolio. I wouldn't put all my savings into an immediate annuity, whether fixed or immediate. I would want some money I can tap for emergencies, so I'd carefully construct a mix of fixed and variable annuities, analogous to allocating assets between stocks and bonds.

The bottom line: I encourage you to look beyond the bad press on variable annuities, do your shopping, and consider variable immediate annuities as a viable part of your retirement income portfolio.

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Steve Vernon

View all articles by Steve Vernon on CBS MoneyWatch»
Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Retirement Game-Changers: Strategies for a Healthy, Financially Secure and Fulfilling Long Life and Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.

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