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In the quest to retire rich, investors are always looking for an edge. Given the turmoil in the markets two years ago, one major consideration that retirement investors keep front and center in their investing strategy is making sure that their nest-egg principal is protected.

One way that investors protect themselves against principal loss is by using variable annuities. Although these specialty investments can indeed limit your downside in the event of a market collapse, they aren't foolproof -- and they also aren't cheap.

The state of the variable annuity
Variable annuities are insurance products, but in many ways, they closely resemble mutual funds. When you buy a variable annuity, you can choose from several investment options; your money is then invested according to whichever option you choose, just as a mutual fund would.

What makes variable annuities different from mutual funds are two things. First, variable annuities are tax-deferred, meaning that as long as you keep your money within the annuity, you don't have to pay tax on the income or capital gains that it generates. Second, the insurance aspects of variable annuities give you additional features that mutual funds lack, such as the choice to lock in guaranteed minimum income payments even if the value of the annuity's investments goes way down.

For those close to or already in retirement, that combination of features sounds perfect. But it isn't that simple. As with equity-linked structured notes that Morgan Stanley (NYSE: MS  ) , Citigroup (NYSE: C  ) , and several other Wall Street banks have offered over the years, the protection that variable annuities offer doesn't come cheap. According to the Wall Street Journal, variable annuity owners pay annual fees that often reach 3.5%. That's well in excess of what 10-year Treasuries pay, requiring the annuity's investments to perform quite well to overcome the drag of annual expenses.

What's in a guarantee?
In addition, the nature and extent of the guarantees have changed. Although Prudential (NYSE: PRU  ) and MetLife (NYSE: MET  ) , which are among the top sellers of variable annuities so far in 2010, have made minimal changes to their offerings, other insurers have added restrictions to their products. For instance, whereas investors in the past could choose aggressively invested all-stock portfolios and still get principal guarantees, many insurance companies now require investors to have at least a certain minimum percentage of their portfolios invested in bonds or other less volatile investments.

The changes in the variable annuity industry make sense when you step back and look at the financial challenges that the companies that sell them have faced. During the financial crisis, many insurers needed help to recover from the market meltdown and other challenges. Among annuity sellers, Hartford Financial (NYSE: HIG  ) and Lincoln National (NYSE: LNC  ) were forced to take TARP money from the U.S. government, while ING (NYSE: ING  ) took similar assistance from the Dutch government.

Protecting yourself
So with all the pros and cons of variable annuities, do they belong in your retirement portfolio? Despite the attractiveness of all the upside of stocks without the downside, the cost is simply too high for most investors to cover. Even when stocks were earning returns of roughly 10% per year, a 3.5% annual fee would have cut that to a net return of 6.5%. Putting that in context, money that would have doubled in seven years at 10% would take closer to 11 years to double at 6.5%.

More recently, with stocks earning nowhere near 10%, a big annual fee can mean the difference between a gain and a loss. And even if you pay up for guarantees, the fact is that if you're certain that you're likely to need to exercise that guarantee, you'd typically be better off just buying a Treasury bond or a bank CD. Even at low rates, something is better than nothing.

Not all annuities are bad for investors, and in certain circumstances where getting more tax deferral is paramount, low-cost variable annuities from providers like Vanguard and TIAA-CREF make sense. But for most retirement savers, it's better to get comfortable with the risk profile you select and invest accordingly.

Worries about your retirement? Find some new ways to get yourself moving in the right direction. Click here to read the Fool's new special report, The 7 Secrets to Salvage Your Retirement Today.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger is wary of costly investments. He doesn't own shares of the companies mentioned in this article. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy ensures your satisfaction.

Read/Post Comments (2) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 23, 2010, at 12:09 PM, LifeDaddy wrote:

    To anyone considering the merits of a variable annuity, it pays to uncover the expenses of any contract you are considering. Although this article is generally correct regarding the fees associated with the VA industry, there are VA contracts available for substantially less than the 3.5% average quoted in the article. The author make reference to the industry leaders Prudential and MetLife. If you are a true Fool (capital F), why wouldn't you consider the lowest cost products if they can provide strong guarantees like the Pru and Met products? Their products have an average fee of around 1.5%, and those fees could be lower with higher account values.

    And consider this: you should only buy the VA product for the purpose of the income stream that it will provide later in life. Anyone who would consider buying any VA only to do a lump sum distribution at a later date, whether it is before or during retirement, should not be in a VA in the first place. Annuities of any form, fixed or variable, are designed specifically for income replacement after retirement. Anyone who feels otherwise does not understand the annuity industry. It should never be for an investment that is short term or even moderate term.

    Lastly, if you are considering a VA for the right reasons, look for guarantees that are offered by any specific product you are looking at. Although your principle value may not be guaranteed, your future income stream can have guaranteed minimum future values along with potential for much higher values in a strong bull market. And in volatile markets, some VAs have built-in tools that will automatically move your principle to substantially less volatile investment sub-accounts that will further protect your principle.

    A variable annuity is an excellent tool for retirement, IF you do proper due diligence by looking for the lowest cost and best guarantees available.

  • Report this Comment On November 24, 2010, at 11:21 AM, MEgdbCT wrote:

    While the majority of this article contains accurate information, the fee/return example significantly understates the benefits of most VA's with lifetime income riders. The article states, "even when stocks were earning returns of roughly 10% per year, a 3.5% annual fee would have cut that to a net return of 6.5%". If annual returns were equal to average returns, then your statement would be more accurate. But they are not. From '29-'09, there were 57 positive years in the S&P 500. The average return in a positive year was nearly 21%. Net of expenses, a VA client's net return would be 17.5%. And during the 24 negative years, the VA client is either gaining 5-7% on their lifetime income base (if in pre-withdrawal mode) or it simply remains constant, ignoring the downside volatility of the markets (if in withdrawal phase). For my retirement income assets, tell me what's wrong with a product that would've yielded me an average net return of 17.5% during up years, and 0-7% (depending on product and if in withdrawal phase) during down years. Oh yeah, and one more thing. My income stream would be guaranteed for the longest living of my spouse and I.

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