"What goes up must come down," says Isaac Newton. Though he was discussing gravity, Mr. Newton's words still ring true in evaluating the current stock market. After 10 years of positive returns, this year may be ending a little less rosy for investors. It's a natural dip, but some market participants are craving a little more safety to help them sleep at night.

In response to that demand, the insurance industry created a product called a variable annuity that promises some downside protection, but less upside potential. It's like having a little bit of both: You're never down that much, but never up that much.

The insurance industry isn't stupid -- it's tapping into a common fear investors have of losing money (see Why are more people aftraid of going broke than dying?). Studies have shown most of us hate losing more than twice as much as we like comparable sized gains. Investors, like people generally, are loss averse and risk averse. So the insurance industry created this Goldilocks investment product; not too hot and not too cold. But does it make sense? What's the catch? Rest assured, my friend, you will not be taken for a fool -- the Retire Guy is on your side. Let's get into this. 

Senior couple sitting back reflecting

Some find the protection of buffer annuities helpful, while others may be better off. Source: Getty images

What is a variable annuity?

First, some background. Understand that all variable annuities share three characteristics:

  1. They are issued by insurance companies. 
  2. You invest in a basket of mutual funds, and the earnings grow tax-deferred.
  3. You can't touch the money until age 59 1/2 -- there are some exceptions --  and withdrawals are taxable income to the extent that your earnings exceed your contributions. Variable annuities also have two layers of expenses, a mortality and expense charge and a mutual fund fee. Some have an advisor fee too, depending on whether or not you buy through a broker. Investors buy variable annuities to defer gains on their investments or to provide a future income stream (called annuitizing). See Should You Buy a Variable Annuity? for a great overview on annuities.  

A variable annuity that promises some upside but less downside is called a buffer annuity, or more accurately a "structured variable annuity." (Now there's a mouthful.)

Here's how it works: Essentially, you make a contribution and spread the investment around a suite of mutual funds inside the annuity. The insurance company then promises to shield your investment from some percentage of loss. (For instance, some products absorb the first 10% or 30% of your investment loss.) You also select your time frame. You can pick the 10% shield for the first year, then switch to the 30% shield the next year.

Your investment will assume any losses beyond these thresholds. For instance, if the market is down 40%, and you selected a 30% shield, the insurance company eats the first 30%, and you lose only 10%. Sounds good, right?

As you might have guessed, this is no free lunch or silver bullet for superior returns. The insurance company can afford to limit your loss because it also limits your upside, depending on the amount of loss protection you selected. This is called a cap rate. For instance, 10% downside protection may come with a cap rate of 8%, and 30% loss protection may come with a 6% cap rate. The more downside protection you select, the less upside you get.

A Goldilocks annuity

Now that we understand the mechanics of this Goldilocks annuity, why would any Fool want to limit their upside? For investors with a long time horizon, or those who can happily stomach the stock market roller coaster, this is not for you. But for an investor who truly fears loss but does want exposure to the upside of the stock market, this product may be worth considering.

Of course, you could always limit your downside by buying bonds along with your stocks; the bonds should smooth out the ride, and cost a lot less than an annuity. It doesn't have to be an all or nothing decision -- you can have some of your money in a traditional mix of stocks and bonds, and some in a structured annuity if that makes sense for you. 

It's important to remember that the insurance company can change the cap rates. The devil is in the details: You'll want to know the history of the company's cap rates, and how much they've changed over time. Also, most insurance companies don't include dividends in the return. So if the mutual fund you select tracks the S&P 500, you get the return of that index without the dividend. That is an important caveat, as dividends can make up a healthy part of an index's return.

Finally, understand the taxes and fees. Taxes and fees are a drag on any investment. Variable structured annuities aren't taxed while you're accumulating money, that's the good news, as more of your money gets reinvested rather than paid in taxes. However, withdrawals are taxable as ordinary income, not capital gains rates which are usually lower. For withdrawals prior to age 59 1/2, there is a 10% penalty on the earnings in addition to the income tax, so you'll want to make sure you don't need the annuity money till after 59 1/2. 

While you don't pay the fee out of pocket on a structured annuity it is taken out of the return. For example, if your investment in the structured annuity was up 8% in a year, your return really is 7% after fees. Fees vary by carrier so it is best to shop it around.   

Structured variable annuities have gotten a considerable amount of press lately, mainly because recent losses in the stock market have spooked investors into wanting more downside protection on their investment.

Can you blame them? It's been a great bull market for the past 10 years, and those who have remained invested have been rewarded. But the recent stock market downturn is a reminder that the market can go down, in fact way down. Be it as it may, those with the mental fortitude to stay invested in market corrections and have time on their side to ride out the storm, may be better off sticking to that game-plan and stay invested. But for those looking for more belts and suspenders than a traditional stock and bond mix can provide, and willing to give up some upside, a structured variable annuity is a possibility. 

The Motley Fool has a disclosure policy.