From the February 2010 issue of Boomer Market Advisor • Subscribe!

The illusion of liquidity

Of the annuities from which advisors and clients can choose, variable annuities are still the most popular. Although the financial crisis forced issuers to boost prices and trim benefits, investors still put more than $100 billion into these products last year.

The living benefits that are available on most of these products seem to offer the best of both worlds: guaranteed income for life plus access to the underlying assets. With the liquidity of mutual funds and the security of an income annuity, what's not to like?

But the lifetime income riders--and almost all variable annuities that are sold with them--aren't as liquid as they look. Contracts that offer to double the income base during the first 10 years, for instance, typically restrict withdrawals during that period.

On the back end, when the owner receives 5 percent of the income base each year, the underlying assets are technically, but not entirely, accessible. If the owner withdraws more than the allotted 5 percent, the income base and the income may drop.

I propose that your clients would enjoy more liquidity if they bought a single premium income annuity (SPIA) with part of their money than if they put all of their money into a variable annuity with living benefits. Ironic but true.

Consider two unmarried 65-year-old men, Mr. Spiano and Mr. Valinco. Each has $400,000 in invested assets and each requires $20,000 a year in addition to Social Security and pension income to cover his minimum annual living expenses.

Mr. Valinco puts his $400,000 into a variable annuity with a payout of 5 percent, or $20,000, and invests his money in one of the prescribed balanced portfolios. Mr. Spiano, who is more risk-averse, sinks $280,000 into a SPIA. To protect $200,000 of it, he opts for a 10-year period certain. He invests the other $120,000 in investment-grade corporate bonds.

Five years later, both men spend $40,000 on new cars. Mr. Spiano takes $40,000 from his bond account, now worth $140,000, leaving $100,000. His income is still $20,000. Mr. Valinco withdraws $40,000 in excess of his guaranteed $20,000 payout, reducing his income base to $360,000 and lowering his income to $18,000.

Hold on, you say. Isn't it possible that a bull market lifted Mr. Valinco's account balance high enough to "step up" his income base? If it reached $440,000 or more on his fifth contract anniversary, he could withdraw $40,000 for a car without sacrificing any income.

It's possible. But the erosion of fees and withdrawals from his account probably won't allow it. Mr. Valinco's account will drop by $32,000 a year if you add 3 percent fees (for income rider, fund management, and insurance costs) to the $20,000 payout. To set a new high, he'll have to earn more than seven percent a year.

Mr. Valinco has more liquidity than Mr. Spiano--but only if he cannibalizes his income. The variable annuity doesn't offer both liquidity and income. It offers either. To maximize income and liquidity without a trade-off, think SPIA.

Kerry Pechter is the author of "Annuities for Dummies" and editor of

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