Billions of dollars are now being invested in variable annuities (VAs), both qualified as well as nonqualified money. Part of the reasons for the attraction of annuities are the guarantees, the so-called "living benefits."

Generally, these are sold on the basis of a guaranteed income that you can't outlive. But what are these living benefit guarantees? While they come with different bells and whistles, mainly there are three:

Guaranteed accumulation benefit: The principal is guaranteed to be returned to the investor, irrespective of market performance, at the end of a certain period, typically ten years assuming no withdrawals have been taken during that time. The investor may or may not be required to invest in the specially designed portfolios of the insurance company. The benefits and the costs to obtain these benefits are very clear and unambiguous.

Guaranteed minimum income benefit: Here, if the investor chooses to keep the principal invested with the company, again typically for ten years, then the principal is guaranteed to increase at a certain compounded rate. The end value after ten years is taken to provide the value for the calculation of an annuitized income stream for life, for a joint life or for a predetermined number of years (the "period certain"). Again, with annuitization the investor generally loses the ability to tap into any principal values. Here also the benefits are clear and the costs are known.

Guaranteed withdrawal benefit (GWB): Most of the variable annuities sold today are sold with the guaranteed withdrawal benefit, or income guaranteed for the rest of one's life irrespective of market performance. In very general terms the concept of the guaranteed withdrawals is simple. A certain percentage amount based on the age at which withdrawals start is guaranteed to be paid to the investor for one life only or for a joint life (with spouse), regardless of market performance. The company may require the investor to put money in its own portfolios, or, if he is given the option of choosing his own funds, then the company may impose restrictions on the maximum equity component. As I indicated at the beginning of this article, there may be some bells and whistles, such as additional interest added to the initial investment for the calculation of the withdrawal benefit or such as annual step-ups to the highest annual or quarterly value.

Advisors should carefully examine the guaranteed withdrawal benefit before advising their clients to invest in these products. Investors would also be well advised to read the prospectuses and obtain illustrations showing the benefits given certain scenarios described in this article.

In a rising market, the guaranteed withdrawal benefit clearly fulfills its objective. On the other hand, one may also say that in a rising market there would certainly be no need for the living benefit at all. (We would save the cost of almost 1.5% that is charged for the total benefit on average.) In a rising market, we could use a non-VA diversified mutual fund portfolio or advisory account to achieve the income goals.

Our concern here, however, is about the benefits that will be paid in a declining market, a stagnant market or even a market that at best returns no more than approximately 8% once withdrawals start. After all, the investor is paying extra fees (in comparison with a non-VA account) specifically for benefits in a declining market.

In order to understand the problems with the GWBs, we need to first understand the history of the death benefits in variable annuities. An important benefit that is added on by most advisors or registered representatives or is incorporated in the annuity is the "guaranteed death benefit." In general, these are of two kinds-the standard death benefit and the enhanced death benefit. The guaranteed death benefit in its basic form states that the investor will receive the initial premiums paid or account value or any enhancements, whichever are higher, when he dies, and that this amount will be paid regardless of market performance.

Before the decline of the market in the years 2000 through 2002, the death benefit was calculated on a "dollar-for-dollar" basis. So, as an example, if an investor invested $100,000 and the market value dropped to $50,000 and the investor died, the beneficiary would receive $100,000. Suppose now the investor did not die but withdrew $48,000 of the value. How much of a death benefit would remain in the contract? Under the dollar-for-dollar scheme, the remaining death benefit would be $52,000 ($100,000 minus $48,000) with an accumulation value of only $2,000. There were many articles in financial magazines, including The Wall Street Journal, on this "loophole" in the contracts. Many investors with or without the advice of advisors have done just that: withdrawn most of the cash from their annuities leaving a large death benefit with little accumulation value. So companies were saddled with high death benefit amounts with low accumulation value.

The insurance companies quickly rectified this situation with the contracts they issued after the market debacle from 2000 to 2002. The scheme adopted was the "pro rata basis" calculation. Here, the death benefit is calculated based on the money withdrawn as a percentage of the accumulation value before the withdrawal, and this percentage is applied to the calculation of the remaining death benefit. Again, taking the example given above, with the pro rata calculation, the percentage is $48,000 divided by $50,000. The calculation would now be $100,000 minus the 48/50 of $100,000, yielding a death benefit of $4,000. In this situation, the investor has an accumulation value of $2,000 with a death benefit of $4,000. What would happen if the value hypothetically dropped to zero because of the markets or client withdrawals? The death benefit would drop to zero. So there is a danger to the investor who withdraws money because he could lose his death benefit.

If the same pro rata calculation is applied to the guaranteed withdrawal benefit, now we see some problems. Most of the variable annuities are sold with two guarantees-the withdrawal benefit and the death benefit. The death benefit works the way it is meant to as long as no withdrawals are made, but once the GWB is exercised, then the market value becomes a component in the death benefit's calculation. So the latter is now subject to the vagaries of the market. If it is based on contract value, then the costs that continue to be charged are truly excessive. In this situation, the death benefit is no longer guaranteed but subject to market fluctuation.

Investors should be informed of this danger to the death benefit, once the GWB is exercised. I posed this question to the regional managers/directors/wholesalers of leading insurance companies. Two leading company managers said that the calculation would be dollar-for-dollar, only to find out it was a pro rata calculation for GWB. They had never heard this issue being raised by anyone, and one manager said it was the first time he had heard of it. Two other regional directors/managers clearly knew of the pro rata calculation. When I explained the problems, one of them said he would inform the home office of the seriousness of the issue. The home office people from the insurance companies knew of the problems that I had raised. I examined the information from nine leading annuity companies. As of this writing, seven of them were doing the calculations on pro rata basis. The only leading companies that still calculated the death benefit on a dollar-for-dollar basis were AXA and the Hartford. In my opinion, they clearly have a competitive advantage.