A viable variable annuity?

(MoneyWatch) Late last year, Vanguard launched a new variable annuity with a guaranteed lifetime withdrawal benefit. This is the first variable annuity I've ever considered for clients, and to learn more about how the product works I spoke with Vanguard principals John Heywood and Tim Holmes.

A variable annuity is an investment vehicle inside an insurance wrapper. In exchange for higher fees, it can provide investors with certain guarantees, such as promising specific cash withdrawal amounts to live on during retirement. Fees for the various flavors of this product generally run about three to four percent annually, which is giving up too much potential return. Vanguard charges far less for this product.

The insurance guarantee

In describing its annuity, Vanguard highlights the same claim that most insurance companies make about such products -- "get lifetime income." What the company means is that it will pay you a minimum cash flow each year. I strongly object to the industry's use of the word "income," as I don't consider the return of principal to be income.

Each year, investors can lock into a new minimum guarantee. For example, if you are 65 years old and have $100,000 value in the account, you can get $5,000 a year, no matter how your investments perform or how long you live. If you want to insure your spouse as well, the annual withdrawal amount would decline to $4,500, but would continue as long as either of you live. The guarantee comes from Monumental Life Insurance Company (in every state except New York, where it comes from Transamerica). Monumental Life has an A+ rating from A.M. Best.

The investments and costs

Two features I like about this new product are its relative simplicity and low costs, compared to other variable annuities. There are only three portfolios to choose from:

-- Balanced portfolio/60 percent to 70 percent stocks

-- Moderate portfolio/60 percent stocks

-- Conservative portfolio/40 percent stocks

Holmes said the total costs of this variable annuity range from 1.45 percent to 1.55 percent, of which 0.95 percent is for the guaranteed annual cash withdrawal amount (again, it's not income).

Is this cost low? Yes and no. It's certainly a bargain compared to most variable annuities. When compared to the cost of an average mutual fund (including turnover), it's probably on par. But compared to the cost of the funds I typically recommend, it's in the stratosphere. I will say that the last comparison isn't fair, as the guaranteed withdrawal amount has value.

My take

I haven't yet recommended this product to a client, but I just might soon. One key feature of this product is psychological. It allows consumers to feel better about tapping their portfolio. And the next time stocks tank, it may also make it easier to stay the course knowing that the cash flow is guaranteed, at least as long as the insurance company stays solvent.

Another benefit of the annuity is that if markets perform well, the guaranteed withdrawal amount may increase. Like most annuities, it can't go down. Unlike most other annuities, however, this one has no surrender charge and the 0.95 percent fee for the guarantee (rider) can be removed at any time.

Here is my opinion of what investors should keep in mind if considering Vanguard's variable annuity:

-- The product is better for women, who tend to liver longer than men

-- It is geared to people with longer life expectancy

-- Buy it when you hit the bottom of an age band

-- Pick the most aggressive portfolio to maximize the guarantee's value

If you have a more expensive variable annuity already, doing a tax-free 1035 exchange to this Vanguard product could lower costs. Vanguard has a cost calculator that's available to determine whether you can save in fees. Because any gain is taxed first by the IRS, and at ordinary income rates, this product may actually be better in one's IRA account. Yes, I realize I just said an annuity could best be held in an IRA account, but that's only because withdrawals are tax-disadvantaged in this wrapper.

This is an insurance product and could fit the bill if you need longevity insurance to protect against outliving your nest egg. It may also help you sleep better at night when markets tank and you need cash to live on. I cannot stress strongly enough, however, what a bad idea it is to put all of your portfolio in this or any other annuity. Remember that if inflation rises, it could eat away at the fixed guaranteed withdrawal amounts.