Why pay more for a variable annuity rider?

Christine Dugas for USA Today writes:   Money Watch, a personal finance column that runs every Saturday, features a financial planner from the National Association of Personal Financial Advisors answering reader questions about saving, protecting and growing your money.

Q: I have a variable annuity that offers a rider that it says would allow a monthly income that is constant without losing control of the principal even if the principal is depleted. What's the catch and are they a good idea?

A: There is normally a catch with annuities, and variable annuities in particular.

I am not a fan of variable annuities for several reasons, including complexity, high expenses, and limited investment choices. The distributions are taxed at ordinary income tax rates. And a variable annuity has no step-up in cost basis for your heirs, which means that if you invest $100,000 in a variable annuity, and it doubles to $200,000, upon your death, your heirs will have to pay taxes, at their ordinary income tax rate, on the $100,000 gain. 

The expenses include mortality and expense fees, which are intended to pay for different kinds of risks assumed by insurance providers under the contract. Those charges can be over 1%. Surrender charges, depending on when the annuity was purchased, can range from 1% to 7% or more. And management fees on the subaccounts can be 1% or more, depending on the underlying investment funds. When you add up these expenses, they can eat up a hefty percentage of your investment dollars. 

Before you look at riders, take a look at the cost of the annuity you have. If the costs are high when compared with a no-load annuity such as those offered by Vanguard, Schwab or Fidelity, consider making a change. And make sure your current contract is past the surrender period, to avoid costly penalties.

The rider you refer to is offered by many companies and is called a guaranteed lifetime withdrawal benefit (GLWB). It does allow you to receive lifetime income while still being able to manage the annuity's investment subaccounts, which, like mutual funds, range from conservative to aggressive investments for the premium payment. The income is guaranteed to continue even if the investment subaccount dollars are depleted. 

How much income you receive can be a fixed percentage of the benefit or income base, determined by the dollars you are investing, your age, and a specified period of time you will receive the income.Typical percentages, depending on age, are 3% to 6%.  Riders, such as the GLWB, cost extra — up to 1% depending on the company offering it and the specific type of rider. The total costs for this product overall are pretty high, at an estimated 3% or more, in comparison with the guaranteed benefit of 3% to 6%.  The reason people purchase these riders is that they are afraid that we will experience another investment year like 2008 and want to make sure their income stream will continue. This product will guarantee that income stream but it does not guarantee the value of the investment subaccounts.

You retain control of your principal but if your circumstances change and you need to take additional dollars out of the annuity, the withdrawals will not only reduce your guaranteed income amount but could eliminate the guarantee you have paid for over the years.

A better alternative may be to annuitize, which is when you convert your annuity into regular payments. Once it is annuitized, it cannot be reversed. Also, withdrawal of the funds within the annuity is no longer possible. The amount of the income stream depends on things like life expectancy and interest rates, as well as payment options. 

And don't forget that the guarantees are subject to the financial health and claim-paying ability of the issuing insurance company.  The bottom line is the details of this type of product are complex and the costs are very high. Read the information provided and make sure you understand what happens when. And if the person who is selling you the product can't explain it in a way that makes perfect sense to you, walk away.