By Scott Burns

If you’re about to make the plunge into a variable annuity with living benefits, I’d like to make a suggestion.

Don’t.

Just as people were once urged to buy term life insurance and invest the difference rather than buy cash value life insurance, today’s living benefits buyer would be better off buying a life annuity and investing the difference.

The alternative I am suggesting has lower costs. It’s easy to do. And it’s likely to produce far better long-term results.

You’ll see why in a minute.

But first, let’s examine the typical living benefits offer.

In a living benefit contract, you usually invest in a diversified portfolio. You pay fees for fund management and the provision of insurance guarantees. In return you get a guaranteed lifetime distribution equal to 4, 5 or 6 percent of the original investment each year for life--- regardless of the value of your underlying investment. Your guaranteed income depends on your age, generally 4 percent if you are age 59 ½ to 64, 5 percent if you are 65 to 75, and 6 percent if you are 76 or older.

The insurance company will typically charge about 2 percent for its guarantees and 1 percent for managing the underlying investment--- a total cost of 3 percent, often more.

As I demonstrated in a recent column, the combination of market volatility and taking 7 to 9 percent from your investments for fees and income virtually guarantees that your income will never rise. It is also likely that many living benefits investors will have a lifetime income, but will die with little or no investment value in their contract.

Query: Is there a way to get the security of guaranteed income, but have a better shot at a rising income and/or having more assets when you die?

Answer: Yes. You can do what researchers John Ameriks, Robert Veres, and Mark J. Warshawsky, suggested a number of years ago--- buy a life annuity to provide the monthly income. Invest the remaining money in a low-cost mutual fund.

Here’s how it works.

A 65-year-old man with $100,000 can currently buy a single life annuity that will provide an income of $632 a month for life. That’s a distribution rate of 7.58 percent a year. It’s also half again as much as the 5 percent guaranteed by a typical living benefits contract for his age. To get the same monthly income as the $417 a month from a $100,000 living benefits contract, he need only commit $65,963 of his $100,000 to a life annuity.

That leaves him with $34,037 to invest in a low-cost index fund. As you can see from the table below, investors at other ages could have up to $50,884 left to invest.

The investor can take investment income from that investment. Or he can reinvest all dividends and interest to accumulate for the future. If he invests in Vanguard Balanced Index fund (ticker: VBINX, expense ratio: 0.25 percent), he is likely to receive an expected return, net of fees, of 7.75 percent. Compounded at that rate, his fund investment would grow to $319,499 in 30 years. Invested in a major domestic equity index with a net return of 10 percent, the same investment would grow to $593,925.

Either way, that’s a lot more than he is likely to accumulate in a living benefits contract. By avoiding the high fees of living benefits contracts, the two-step life annuity/mutual fund investor has the prospect of either (1) seeing his money multiply many times or (2) experiencing some increase in both income and principal.

So what’s the catch?

It’s in apparent versus actual value.

The living benefit investor has a starting balance of $100,000 even though the actual value of his guaranteed income stream is much less--- probably not much more than $60,000. The buy-a-life-annuity-and-invest-the-difference investor, on the other hand, sees a large part of his nest egg appear to disappear into a life annuity. Rather than see a $100,000 apparent account value, he sees only the value of his new mutual fund account, somewhere around $40,000. The real value of his investment, however, is the value of the life annuity and the mutual fund, about $100,000.

Over time the two-step investor will get to see the mutual fund investment increase while enjoying the same monthly income as the living benefits investor.

Buy a Life Annuity… and Invest the Difference

This table compares the income rates, at different ages, of living benefit contracts and single life annuities for males based on a $100,000 investment. The life annuity rates would be somewhat lower for single females or joint and survivor annuities. Because life annuities provide more income, an investor can get the same guaranteed income with a smaller investment. This leaves money available to invest that will grow faster in a low cost index fund because it will not be burdened with the dramatically higher expenses of a living benefits contract.