by Scott Burns

    The advertisements are inescapable. Before I knew it, I had pulled big sticky inserts from four different publications, all telling me about "the Retirement Red Zone" and the benefits of the "HD Lifetime Five," a variable annuity with living benefits from Prudential.
   
    In case you haven't heard about "living benefits," they are the newest wrinkle in variable annuities, magically providing income guarantees while you are living rather than a minimum value guarantee when you are dead.
    It's not difficult to understand why they are so popular. Most people worry about not going broke while alive. Providing for beneficiaries is icing on the cake.
   
    So what is a living benefit?

    The basic offer from Prudential is pretty straightforward. You invest your money in one of its portfolios of funds. If brilliant management causes it to grow beyond your wildest dreams, you'll be both richer and more secure.

    If it doesn't, you've still got some nice guarantees. Prudential guarantees that your investment will grow at 7 percent a year if you delay taking any money for 10 years, 5 percent if you start taking money before 10 years.

    Whenever you do start taking money out, you can take it at 5 percent of the maximum value the account has reached. And you can take it forever, regardless of what happens to your account value. Even if the markets tank horribly and your annual withdrawals empty the account, you'll still get the original income until you die. Pay a smidgeon more, and your spouse will get the same amount until his or her death.

    On the bright side, if the account grows, your income may grow as well. And the principal you leave behind could be greater than your initial investment.

    What magic! You've got upside potential with lifetime income.
  
    So I went to the Web site (www.retirementredzone.com), left an e-mail requesting the names of local sales representatives, received a list within 24 hours, made calls, and found one who could see me in a few days. He turned out to be a pleasant fellow with 25 years of experience in insurance products.

    He walked me through a series of illustrations. The first was what would happen if I started immediate withdrawals but enjoyed a gross return of 9.74 percent. It was, he said, representative of returns over the last 30 years. In the particular sequence of returns illustrated, investing a cool million would bring a starting income of $50,000 that would grow to $71,835 over the next 20 years as the original investment grew to $1.3 million.

    Nice.

    If the gross return was only 6 percent, however, the income would stay fixed at $50,000 for the entire period. And the account would lose more than half its value. If the gross return was 0 percent, the income would stay fixed at $50,000, but it would continue for life even though the account would be exhausted in the 16th year. That's the living benefit.

    So what's not to like?

    Start with staggering expenses. The advertisement lists a portfolio expense of 1.20 percent, a charge of 1.65 percent for the variable annuity contract and an additional 0.60 percent for the lifetime income guarantee. That's a total of 3.45 percent a year that comes off the gross return. (There are variations on the contract that would take the total cost down by 0.60 percent after a period of time to 2.85 percent.)

    Basically, every dime of dividend and interest income will be going to the insurance company, not you. Your income will come out of principal growth or, lacking that, principal. The gross return has to top 8.45 percent before there would be any possibility of growth since you may also be taking out 5 percent.

    That puts a lot of weight on the performance of the underlying funds used to create the portfolio. Sadly, there is little good news there. While the expected gross portfolio return of 9.74 percent is reasonable, according to long-term returns calculated by Ibbotson Associates, an embarrassing proportion of the funds were bottom 50 percent performers, according to Morningstar.

    Most trailed their cost-free index targets. In the entire list, only a few funds were rated above average by Morningstar. The others, a far larger number, were rated average or lower.

    In addition, most of the performance figures were calculated by Morningstar using lower expenses than the 3.45 percent cost of this product, so returns net of expense would be still lower. That makes me think investors will be fortunate to have a net return much over 5 percent.

    That means you'll get your 5 percent income, for sure, but your beneficiaries will get somewhere between your original investment and zilch. In effect, you've got a life annuity with an upside kicker of dubious value.

    So let's compare this choice to a traditional life annuity -- one where you give up your principal in exchange for a fixed lifetime income. According to www.immediateannuities.com, a deposit of $1 million by a 65-year-old male would bring a monthly check for $6,720, or $80,640 a year. A 65-year-old woman would get $6,260 a month, or $75,120 a year. (Your actual annuity income would increase or decrease, depending on your age at issue.)

    Either way, the income is lots higher than $50,000.

    The only income for life that the Prudential product guarantees is that 5 percent, or $50,000 a year. That's a fraction of what you would get from an actual life annuity. The income differences are $25,000 to $30,000 a year -- for life. Basically, "living benefits" requires giving up a whopping amount of current income for the slender possibility of income growth and the hope of leaving some money to your heirs.

    Is there a better choice that offers the same lifetime income security?

    You bet.

    Divide your portfolio into two pieces, a life annuity and a diversified portfolio. In this example, you would put $620,000 into a life annuity. That would give you the same $50,000 a year that Prudential guarantees for life.

    But you'll also have $380,000 "leftover" to invest in a portfolio that can grow without the stupefying drag of 3.45 percent a year in expenses.

    Left to grow unimpeded for 20 years at 9.74 percent, less expenses of 0.50 percent, your $380,000 would grow to $2,225,000. With expenses of 1 percent, it would grow to $2,030,000.

    Is Prudential just a "bad apple" in a wonderful crop of living benefits insurance products? Not at all. The agent made all the required disclosures. This product, and other living benefits offers, seems magical until you consider alternatives.

    Bottom line: The common characteristic of "living benefit" variable annuities is incredibly high fees (generally pushing 3 percentage points a year) and an income guarantee that is way below what you could get with a traditional life annuity. You're better off with a traditional life annuity and a low-cost diversified portfolio.