Vanguard has a new guaranteed-income rider for its low-cost variable annuity that can make sense for some risk-averse investors. By Steven Goldberg, Contributing Columnist November 9, 2011 I never thought I'd write a positive article about a variable annuity. As an investment adviser, I get sales pitches almost daily touting the huge commissions I can make selling these products. The high costs of variable annuities, often 3% or more annually, usually makes them an awful deal for investors.SEE ALSO: Are Annuities Right for You? But Vanguard has a new income rider for its variable annuity that’s making me reconsider. With the rider, total annual costs are 1.45% to 1.55% for a balanced portfolio of stocks and bonds, as well as a guarantee that you’ll receive a fixed sum annually -- no matter how far the markets decline. The Vanguard annuity costs quite a bit less per year than a similar annuity offered by Fidelity, Vanguard’s biggest fund rival. (See Index Fund War: Fidelity vs. Vanguard.) Variable annuities are a hybrid: part investment, part insurance. You invest in mutual fund-like vehicles, but the gains and losses are tax-deferred inside the annuity until you withdraw money. Advertisement Vanguard is able to offer such a good deal on its variable annuity because it has no profit-seeking owners. Instead, Vanguard’s fund shareholders own the firm. That means Vanguard can provide products at cost, rather than trying to turn a profit. Here’s how the annuity works. To take advantage of Vanguard's guaranteed payout option, you can choose from among three investment options. The first -- and best, in my view -- is an actively managed balanced fund that’s a clone of the superb Vanguard Wellington Fund (symbol VWELX). Wellington keeps 60% to 70% of assets in stocks and the rest in bonds. A second, moderate-allocation choice invests 60% of assets in Vanguard stock index funds and 40% in bond index funds. The third choice, which features a more conservative allocation, keeps 40% in stock index funds and 60% in bond index funds. The Wellington option costs 0.60% annually; the others cost 0.50% a year. The wrinkle that Vanguard has just added offers a guaranteed lifetime withdrawal benefit for an additional cost of 0.95% a year. It’s easiest to explain the withdrawal benefit with an example. Say you invest $100,000 in a Vanguard variable annuity. If you’re between 59½ and 64 years old, you withdraw 4.5% of the principal, or $4,500, in the first year (a couple would withdraw 4%, or $4,000). If you’re older, you start with a slightly higher initial withdrawal percentage. Advertisement The stock and bond markets rally, and the next year your investment account grows to $110,000, more than making up for your $4,500 withdrawal. Instead of withdrawing $4,500, you take $4,950 (4.5% of $110,000) from your account. Say the markets fall the following year, and your investment account shrinks from $110,000 to $90,000 (partly due to your $4,950 withdrawal). Thanks to the guarantee, you still receive $4,950 that year. In other words, your minimum annual withdrawal benefit can’t ever shrink below its high-water mark. But if the markets subsequently rally, your high-water mark can be reset at, for example, $120,000 or $130,000 or $150,000, depending largely upon how your investment account performs. Investment accounts are valued once a year for the purpose of computing your high-water mark. The value of your account rises and falls with the markets but also declines with your annual withdrawals. The problem with many variable annuities that contain this type of guaranteed benefit is that the costs are so high that you need a sustained bull market for your high-water mark to rise. Many investors in variable annuities find that they are stuck with their initial withdrawal benefit for the rest of their lives. Advertisement The Vanguard variable annuity guarantee has a price, too, but it’s refreshingly low. Vanguard currently contracts with Monumental Life Insurance Company and Transamerica Financial Life Insurance to provide the guaranteed withdrawal benefit. Because Vanguard is so large, it can negotiate good deals with insurers. Unlike many other variable annuities, moreover, Vanguard’s product is flexible. Say your investment account grows over the next decade, and you gain confidence that you don’t need the guaranteed withdrawal benefit. You can ask Vanguard to remove that benefit. You’ll still have a variable annuity, but your price will drop by 0.95 percentage point annually. Vanguard has offered a variable annuity without a guarantee for years. It offers additional investment options that are more aggressive than the ones offered in this new program. Other financial advisers and I often use the older Vanguard variable annuity as a place for clients to transfer higher-priced variable annuities. I don’t recommend variable annuities for most clients. Neither does Vanguard. In coming years, it’s unlikely that the stock market will perform anywhere as wretchedly as it did in the past decade. That means that most people will do better in retirement with a well-diversified investment portfolio held in regular accounts. You should be able to withdraw 4% or 5% annually from such a portfolio and give yourself an annual cost-of-living adjustment. Advertisement Why not pay 0.95% annually for the guaranteed withdrawal benefit? Because even such a low price will place a big weight on your investment returns over time. If you need guaranteed income, consider an immediate fixed annuity. It offers much higher payouts than a variable annuity does, although you surrender all rights to the money you invest. (See VALUE ADDED: Buy a Pension with an Immediate Annuity.) With a variable annuity, you can withdraw more money than your guaranteed benefit, although that reduces the overall value of your investment account, and your guaranteed benefit shrinks proportionately. Still, should you have an emergency and need cash, you can get it from a variable annuity -- but not from a fixed immediate annuity. Is the Vanguard annuity right for you? If keeping 50% or 60% of your money invested in the stock market keeps you up at night, you should consider the Vanguard product; it’s not a bad option. For more details, see the brochure, “Guaranteed Lifetime Withdrawal Benefit through the Vanguard Variable Annuity.” Vanguard also offers a free cost calculator that compares the price of any variable annuity to what Vanguard offers. Once you’re past the period during which a high-cost variable annuity levies a surrender charge, it can make sense to move to the Vanguard variable annuity. You can’t start receiving your annual payout without a federal tax penalty until you turn 59½. If I were younger than that, I wouldn’t consider an annuity. All annuity payouts are now low because interest rates are microscopic. If you can wait for rates to climb, you probably should. But if you need guaranteed income and you’re averse to risk, it’s nice to know you finally can buy a product that’s fairly priced. Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.