The pros and cons of variable income annuities

- Alan Lavine and Gail Liberman

Every year, you probably worry whether your CD interest rates will keep up with your expenses, which have been rising at 2 to 3 percent annually.

What makes matters worse: If you invest in bonds or bond funds, the value of your principal can drop if you need to sell after interest rates have risen. That's because bond prices and interest rates move in opposite directions. So if interest rates have increased, why would anyone want to buy a lower-rate investment from you?

One solution to this problem may lie in an immediate annuity.

An immediate annuity is a contract with a life insurance company. You get monthly income for as long as you live, based on a lump sum investment. In addition, you only pay taxes on about one-half of the income you get from it. The IRS considers the rest a return of principal.

There are two types of immediate annuities: A fixed income annuity and variable income annuity.

Beware that if you die, your insurance company pockets your investment in either of these annuities--unless you structure it to continue to provide income to your spouse or beneficiaries. Expect to get less income if you opt for this type of structure.

A fixed income immediate annuity generally issues you a monthly payment, guaranteed by the insurance company, for as long as you live. This type of immediate annuity is attractive for older retirees in their late 70s and 80s because it provides a secure source of income.

The variable immediate annuity, on the other hand, lets you invest in a selection of securities---usually, stock and bond mutual funds--for a potentially better long-term return. Because its investments tend to pay more over time, your monthly payment from a variable immediate annuity may be higher than with a fixed immediate annuity. This can offer added protection against inflation.

Variable immediate annuities are best suited to the younger retired set in their 60s. Reasons:

The income from a variable immediate annuity should keep pace with rising costs because all or part of the money is invested in stock funds, which historically have returned more over time.

On the other hand, the stock market can be volatile. You may need more time for the investment to rebound. Historically, there has been one bad year for every three good ones in the stock market, according to Ibbotson Associates, Chicago.Variable income annuities are a little tricky. You select a benchmark return that generally can range from 3 percent to 7 percent. Should you earn exactly the benchmark, the income will remain unchanged. If the fund's performance is greater than 3 percent, for example, the income will increase.

But what if the investments perform worse than 3 percent? Most variable income annuities have a floor level of income below which the monthly benefit is guaranteed never to fall. Unfortunately, that floor is lower than the payout you likely would get from a fixed immediate annuity.

There's no free lunch with variable immediate annuities.

• If the stock and bond markets perform poorly, you may not get the income you expected. From 1974 through 1980 for example, the income from a fixed immediate annuity paid more than a variable income annuity that invested in stocks.

• Variable income annuities often come with high annual fees.

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Spouses Gail Liberman and Alan Lavine are syndicated columnists. You can purchase Alan Lavine & Gail Liberman's latest book Quick Steps to Financial Stability (QUE Publishing 2006) online at www.moneycouple.com or at your local bookstore. E-mail them at MWliblav@aol.com.