Vanguard offers a deferred variable annuities with a rider called a "Guaranteed Lifetime Withdrawal Benefit." I would like to know the pros and cons. — Frank, North Carolina

Speaking generally, a variable annuity is a tax-deferred vehicle that allows you to invest in a variety of choices, typically stocks, bonds, money market instruments or some combination of the three. When you buy a deferred variable annuity you don't start receiving any payments from the contract until you specifically request them.

One good feature about the Vanguard product is the guaranteed lifetime withdrawal benefit (also known in the industry as a guaranteed minimum income benefit). This is a fail safe that protects you from market volatility. For instance, if you select an annuity with a guaranteed lifetime withdrawal benefit of 5% a year, you can be certain of receiving that 5% a year for the rest of your life even if the markets perform terribly and the value of your annuity goes down. Without it, your annual payout could be a good deal less.

There are other pluses. If the annuity's investments perform well, your annual benefit can also go up. In addition, spousal or "second to die" benefits are often attached to these types of contracts. This means it can cover two lives.

Still, they're far from perfect. Although Vanguard doesn't charge sales commissions and their fees are a relative bargain in the annuity industry, costs can add up. Vanguard charges somewhere in the neighborhood of 1.5% in fees per year (other annuities are as high as 2 or 3%). On a $150,000 contract, that 1.5% translates to $2250 a year.

Taxes are another significant issue, says Don Grant, a financial planner in Wichita, Kansas. Although funds in the annuity grow tax deferred, gains — even long-term ones — are taxed as ordinary income and not at the often more favorable capital gains rate. Additionally, beneficiaries who inherit the balance of an annuity will also inherit the deferred tax bill, while investments outside of an annuity are generally stepped up at the owner's passing.

For more on caveats to take into account when considering annuities, have a look at Walter Updegrave's take in a recent "Ask the Expert" column.

-- Jeff Wuorio

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