Annuities and other products promise secure income. But only some deliver. By Kimberly Lankford, Contributing Editor and Elizabeth Leary, Contributing Editor March 31, 2009 What shellshocked investors crave most today is a guaranteed return on their money, and investment firms and insurance companies are happy to oblige. Their aggressively marketed products range from annuities with attractive annual payouts to more-exotic hybrid investments that promise to return your money and more -- if everything works out. Sponsored Content RELATED LINKS VIDEO: Do-It-Yourself Pension Guide Revive Your Retirement Retiress and the Shrinking Nest Egg Can you count on those tantalizing assurances? It depends on the financial strength of the companies that offer them and the safety nets that back them up. We looked at four investments that promise to protect your money or pay up based on certain guidelines. We found that some are better than others at keeping their promises. Annuities: Income for Life Retirees began flocking to variable annuities with guaranteed benefits a few years ago. These insurance contracts often involve lump-sum investments of $100,000 or more. In return, you can count on generous annual withdrawals without fear of outliving your savings. Advertisement But the assurances come at a steep price. Investors often pay from 0.6% to 1% of their initial investment amount -- on top of a standard annuity fee of about 1.4% a year -- for guarantees that include minimum withdrawal benefits or minimum income benefits. With a guaranteed minimum withdrawal benefit, you can tap up to a certain amount each year -- often 5% to 6% of your initial investment for the rest of your life, no matter how the annuity's underlying investments perform. Some annuities even allow you to boost your annual withdrawals if your account value increases, creating an income substantially higher than you could safely afford to withdraw from your own savings without fear of running out of money. A variation, called a guaranteed minimum income benefit, also allows you to withdraw up to a certain amount of your initial investment each year (typically 5% to 6%) until the account is nearly depleted. At that point, you can convert the initial value of your investment into a lifetime stream of income, a process known as annuitization. Although you give up control of your money (the insurance company retains any leftover funds after your death or the death of your beneficiary), you may be able to increase your annual withdrawals to 8% or more. The older you are when you annuitize, the higher your payouts. How Strong a Net? When Lynn DiGiovanni of Spring, Tex., retired from Exxon in 2007, she bought a variable annuity from Allianz Life Insurance. Lynn, then 55, and her husband, Richard, were attracted by the promise that after ten years their initial investment would be worth at least twice as much for the purpose of calculating withdrawals, no matter how their investments actually performed. At that point, they could begin to withdraw 5% of the higher guaranteed amount every year as long as either of them remained alive (and more if their investments performed better than expected). "We come from families with great longevity and we wanted some guaranteed income," says Lynn. "This allowed us to invest with a built-in safety net in the event the economy deteriorated." Advertisement That safety net, which allows them to base their future annual withdrawals on the higher guaranteed account value, is looking pretty good to the DiGiovannis right now. Their account took a big hit in the stock-market meltdown and is now worth about half of their original investment. Although they will be able to cash out penalty-free once their surrender period expires in four years, they may not want to if their investments don't rebound. That's because if they wanted to cash out, they would be able to tap only the actual, reduced amount of their account, not the higher guaranteed amount that is used to calculate annual withdrawals, says Michael Bartlow, co-founder of AnnuityGrader.com. If, however, their investments do outperform the guaranteed return, they could base their annual withdrawals on their actual account balance. Or they might want to take the money as a lump sum and run. Surrender periods typically range from three to seven years on these types of annuities. (Cashing out before the surrender period ends can be very expensive, often costing you as much as 7% of your initial investment in the first year. The penalty declines to 1% in year seven and then zeros out.) More-typical investors, who begin taking 5% or 6% withdrawals immediately, may be tied to their annuities forever because those substantial withdrawals coupled with poor market performance could severely deplete their account balance. Normally, financial advisers recommend that retirees limit their initial withdrawal to 4% of their savings, with slight increases in sub-sequent years to offset inflation. "They're tapping their money at a more aggressive rate than they would have if they didn't have an insurance company behind them," says Chris O'Flinn, president of ElmAnnuity.com, in Washington, D.C. Limiting Their Risk So far, insurers haven't had trouble making good on their guarantees. But many of them are altering new annuity products to limit their future risk by increasing fees and reducing guaranteed withdrawal rates. In most cases, insurers can make only limited changes to existing annuities, such as eliminating some of the riskiest funds from their investment lineup. Advertisement Money invested in variable annuities is segregated from an insurer's assets and invested in mutual-fund-like subaccounts of your choosing. So your actual account value should be protected from any financial troubles encountered by the insurer. But the guaranteed benefit is paid from the company's general account and could be in jeopardy if the company became insolvent (see the box below). RELATED LINKS VIDEO: Do-It-Yourself Pension Guide Revive Your Retirement Retiress and the Shrinking Nest Egg It's important to investigate your insurer's financial strength before buying a variable annuity (you can check A.M. Best's ratings free at Kiplinger.com). If you plan to make a large investment, consider splitting it among several insurers so you don't exceed your state's protected limit on individual annuity contracts. For details, go to the Web site of the National Organization of Life and Health Guaranty Associations. Stable Value: Worth a Look When Jay Debandt of Vancouver, Wash., was looking for a secure investment for the fixed-income portion of his General Motors 401(k) money, he invested a chunk in Promark Income fund. This stable-value fund has earned as much as 7% to 8% in some years, and recently returned 4% to 5% -- a much better rate of return than money-market or bond funds. Stable-value funds, which hold about $400 billion, are offered primarily through employers' defined-contribution plans, such as 401(k)s. The funds generally invest in high-quality bonds with maturities of two or three years, plus they buy insurance "wrappers" that guarantee the principal. To further protect themselves, most stable-value funds are backed by several different insurers. Advertisement The average stable-value fund returned about 4% in 2008, and, until recently, no stable-value fund had ever lost any money. In December 2008, a stable-value fund that Invesco managed for Lehman Brothers' 401(k) plan lost 1.7%; for all of 2008, the fund still gained 2.2%. But the news alarmed investors, especially those whose employers' finances were similarly precarious. The Lehman fund's write-down is likely to be a one-time event. That's because three of the seven insurers that covered the fund had specified that their wrappers would become invalid in the event of bankruptcy. When that happens, a stable-value fund generally negotiates new contracts to maintain coverage. But Lehman's abrupt bankruptcy left it with no time to renegotiate the contracts -- at exactly the same time when many former employees were withdrawing money from their 401(k)s, forcing the fund to sell bonds at a loss. Now, all of the fund's remaining assets are again insured against loss. Stable-value funds have weathered past bankruptcies without losing any money, says Gina Mitchell, of the Stable Value Investment Association. "A corporate event, such as a bankruptcy, layoff or early-retirement program, is usually anticipated and planned, which gives the plan sponsor time to work with the banks and insurance companies that protect the stable value," she says. "The Lehman Brothers situation was unique in terms of size, scope and speed." David Babbel, professor emeritus at the University of Pennsylvania's Wharton School and author of a study on stable-value performance, agrees. "If this is the worst that can happen, it underscores the attractiveness of stable-value funds," Babbel says. Because of GM's financial problems, Debandt asked a lot of questions about Promark Income fund's investments and insurance wrappers, and discovered that it was covered by three highly rated insurance companies. He ended up rolling over his 401(k) to a Fidelity IRA so he'd have more investment options. But Debandt was disappointed to learn that an accounting rule prohibits stable-value funds from being offered through IRAs. "I wish I had left my fixed-income asset allocation in the GM 401(k) program just to take advantage of the Promark Income fund," he says. ETNs: Proceed With Caution One bullet point on the long list of Wall Street innovations in recent years is exchange-traded notes, which came to the market with much hoopla in 2006. ETNs promise to track an underlying index or commodity -- say, the Indian stock market or the price of cotton -- that doesn't lend itself to the creation of an ordinary index fund. Like their popular cousins, exchange-traded funds, ETNs are bought and sold just like stocks. But look under the hood, and you'll find that ETNs are just bonds that use idiosyncratic ways to determine returns. Issuers -- Barclays and Deutsche Bank are two of the largest -- market these debts with the vow to pay a return equal to that of the underlying index. The notes pay no interest until maturity, at which point ETNs repay the original principal plus or minus the total return of the underlying index over the lifetime of the note. "You're really buying a promise that the issuer of that ETN will deliver," says Bill Koehler, chief investment officer of ETF Portfolio Solutions, a Leawood, Kan., money-management firm that specializes in ETFs. Between the ETN's issue date and its maturity, the market price moves in line with its underlying index. The promise runs aground, however, if the issuer goes bust. Lehman Brothers had three outstanding ETNs at the time of its collapse last September; two followed commodities and one tracked publicly traded private-equity firms. But ETNs contain a mechanism that allows large holders to redeem the notes with their issuer, says Morningstar analyst Bradley Kay, and most investors had already redeemed their notes with Lehman by the time it went under. However, the ETNs had stopped trading by the time Lehman filed for bankruptcy, so anyone still holding them would have had no choice but to get in line with the company's other unsecured creditors. It is possible, though, for an ETN to survive the financial ruin of its sponsor. When JPMorgan Chase acquired Bear Stearns in May, it also took over management of Bear's energy-infrastructure ETN; the note's market price barely registered a blip during the turmoil. Still, the added credit risk should make you think twice before buying an ETN. Complex Promises If there were ever an award for "Most Contrived Investment," principal-protected products would bag the title in a heartbeat. The appeal of their promise is instantly compelling: the return of 100% of investors' principal investment, plus the potentially limitless gains of an underlying index. But that promise is typically bound up in such a Gordian knot that the aim of the products gets tripped up along the way. These complex critters may be issued under cute acronyms, such as Astros, Bridges or Mitts, or they may simply be called principal-protected notes. The notes, which are unsecured debts, usually act like zero-coupon bonds -- they pay no interest along the way but at maturity deliver a lump sum, consisting of their principal value plus any appreciation of the underlying index. How much of the index's appreciation investors can tap into often depends on an absurd array of caveats. For example, one line of JPMorgan Chase notes promises to return the price appreciation of Standard & Poor's 500-stock index from the notes' issue date on January 31, 2008, until maturity on May 1, 2009, up to 19.25%. But if the S&P 500 closes at a certain level or above on any day over the notes' lifetime, they won't return a cent above the principal value. Moreover, principal-protected notes are usually tied to the value of the underlying index, rather than to its total return, meaning investors miss out on any dividends. In a nutshell, the returns on these notes may not amount to peanuts. And just how good is the principal protection? If the Securities and Exchange Commission filing for the product clearly states "principal protected" or "100% principal protection," it's pretty solid. However, principal protection for notes that carry "contingent protection" or "partial protection," or those that are labeled as "buffered," kicks in only under certain circumstances. You might be protected if the underlying index declines 15%, but lose protection against any further declines. Solid as it may be, you'll receive the full principal protection only if you hold the notes until maturity. "These are buy-and-hold instruments," says Keith Styrcula, chairman of the Structured Products Association. "You don't get the full benefit of the principal protection unless you hold them for the long term." At the end of the day, principal-protected notes are merely unsecured debts. They may one day have a place in your portfolio, but that day hasn't come yet. Says Styrcula: "In theory, this should be a simple and elegant product for conservative investors, but it doesn't always work out that way."