Variable annuities: Beware of shrinking payouts

Angling for more retirement income? Variable annuities are not as generous as they once were.

(Money Magazine)

Driving most of those sales was not the annuity itself, essentially a tax-deferred investment account; rather, buyers have been attracted by the "living benefit" rider, an optional feature ensuring that you can draw a base income from your investments regardless of how the markets perform or whether you drain your account.

Before the financial crisis, riders commonly guaranteed impressive returns of 8%-plus and annual withdrawals around 7%. So it was no wonder that over a period that included two bear markets Americans eagerly rushed into these insurance products, seeing them as the antidote to investment risk.

These days, however, the variable annuity and rider combination isn't looking like the panacea it once seemed to be.

Over the past 18 months, most of the insurers that sell these products have seriously scaled back guarantees offered on new contracts while hiking fees and restricting investment allocations on both new and existing policies.

Seven major firms, including AXA, John Hancock, and Prudential, have limited or prohibited additional investments in some of their older, more generous contracts. A few companies have even offered buyouts to customers willing to cancel the rider.

Meanwhile, the Securities and Exchange Commission is now looking into whether buyers were ever made fully aware of the potential for such changes.

What's going on? First, the financial crisis tanked customers' portfolios, putting insurers on the hook for billions in guarantees on pre-2008 contracts. Since then, years of low interest rates have left firms uncertain that they will be able to satisfy future payouts.

"A lot of companies got burned," says Moshe Milevsky, a finance professor at Toronto's York University. Besides rejiggering the terms on their contracts, many insurers have reduced the number of policies they sell; last year two big names -- Hartford and Sun Life -- dropped out of the business altogether.

Related: The Social Security mistake that could cost you thousands

If you have a VA or were thinking of buying one, you're probably wondering where all this leaves you. For owners, the answer depends on your contract, your account value, and the changes to your terms.

For income shoppers, it ultimately comes down to what risks you can accept -- though there are cheaper, simpler, and more profitable ways to ensure that you won't outlive your money.

The sections that follow will help you make the right decision for you.

What the changes mean

While each insurer is tweaking its terms differently, there are a few common threads: limited investment freedom, tightened minimum-return and income guarantees, and higher fees.

The most common -- and arguably most impactful -- shift has been to cap owners' stock allocation. Through the VA itself, investors used to be able to choose from a large menu of mutual funds. You could go whole hog into stocks, if you so desired, knowing you had the rider's guarantees as a backstop.

Related: Annuity payment calculator

Today most buyers who opt for a rider -- 88% do, says research firm LIMRA -- will see their stock stake capped at around 60%. You may also be required to use model portfolios or "managed-volatility" funds, which automatically shift assets from stocks to more conservative choices if your account value falls a certain percentage within a short time.

Such restrictions can have a huge impact on the value of the rider because of how the vehicle is structured.

First thing to know: While the actual money you've stashed in a VA-with-rider fluctuates with the value of your investments, a hypothetical account called a benefit base grows at a minimum "roll-up" rate each year -- say, 5% -- even if your real-life investments lose money. If your actual investments do better than this guaranteed return, the benefit base is increased, or "stepped up," to match them.

The rider also has a set schedule of guaranteed withdrawal rates based on the age you start collecting. Whenever you decide to start taking income, the percentage is applied to your benefit base to determine the amount. Then the money is drawn from your actual account.

You can generally tap the account for more, if needed, as well, though it will affect your future income. In the most popular kind of rider, known as the guaranteed minimum withdrawal benefit, the insurance kicks in once withdrawals drain the account, allowing you to continue receiving the same amount for as long as you live. (If you die before depleting the account, your heirs get what's left.)

Investment restrictions decrease the chances that your portfolio will suffer a major downturn, thus decreasing the chances the insurance will come into play at all. Also, the smaller your stock allocation, the less potential for step-ups. "If you're forced to have a balanced allocation, what's the point of buying protection?" asks Milevsky.

Changes in guaranteed income further diminish the rider's value. Two years ago 70% of riders offered a 5% withdrawal rate. Now less than 50% do, says Morningstar.

A lower withdrawal rate means it takes longer for your account to run out and longer for the insurer to have to shell out its own money. Roll-up rates have drifted down too, from a typical 8% to around 5%, and some companies have found ways to further limit them (such as capping the number of years).

More: Rising fees

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