The worst retirement investment you can make

If the underlying investments returned 8% a year, after 30 years:

• Your variable annuity would be worth $362,177.

• Your mutual funds would be worth $431,874 -- a difference of nearly $70,000, or 14 years' worth of contributions.

The gap just widens if you consider the tax implications. In both scenarios, you won't have to pay tax on your original contributions when you withdraw the money. But the mutual fund gains would in most cases qualify for capital gains tax rates, which range from 5% to 15%, while the annuity's payments would be taxed at income tax rates -- currently 10% to 35%.

Are the life benefits worth it?

Meanwhile, the chances of your actually using the insurance benefits are slim. Relatively few people will die with their annuities worth less than what they paid. The living benefits typically come with a 10-year holding period, and there have been few 10-year periods where investors have actually lost money.

Insurers argue that the life benefits serve as "guard rails," allowing investors to take more risk with the knowledge that their basic investment is protected. Many financial planners respond that a more appropriate response to risk is to construct a balanced, diversified portfolio with bonds and cash to cushion stock market swings.

"The appropriate way to handle the risk is to run it down to where you can sleep at night," Armstrong said, "not to jack up your expenses and pay horrendous taxes on the other end."

Of course, most variable annuities aren't bought -- they're sold. Only about 2% of variable annuities are purchased directly by consumers; the rest are sold through brokers, insurance agents and bank employees who are paid often-hefty commissions on their sales.

The math is lousy

"Nobody who's in the fee-only (planning) business is going to recommend them," said Armstrong. "Why do you think that is? You think we just have a blind spot that we can't do the math?"

Some of most vociferous critics of variable annuities are those who, like Armstrong, spent some time in the brokerage firms or insurance companies that push them. Before he became a fee-only planner, Rob Pool of Portland, Ore., worked for a major brokerage firm, and the experience made him wary of the way annuities are sold.

"They'd get recommended even if it wasn't in the client's best interest all the time," Pool said. "I can't say there's never a place for a variable annuity in a portfolio, but I haven't found it yet."

The uses are very limited

Armstrong says he has -- but only in one scenario: a high-income client who is afraid of lawsuits and won't consider a trust. Some states, like Florida, protect annuities from creditors' claims.

Even that risk gets distorted in annuity sales pitches. As I wrote in "Beware an annuity salesman's scare tactics," the National Association of Securities Dealers recently accused several companies of exaggerating the risk of lawsuits to frighten elderly customers into buying high-cost, high-risk annuities to protect their assets.

Most people can get sufficient lawsuit protection by increasing the liability limits on their homeowners' and auto insurance policies. For those who want more, "umbrella" or personal liability policies can offer coverage of $1 million and up.

If, after all this, you're still considering a variable annuity, you should take the following steps before you buy:

• Make sure you have maxed out all your other tax-deferred options -- 401(k)s, Roth 401(k)s, IRAs, Roth IRAs, etc. -- and want to save more for retirement. Even then, you first should consider all of the other methods of saving.

• Be certain you can leave the money alone for at least a decade and preferably two. It takes years for the tax benefit to outweigh variable annuities' added costs. Analyses by T. Rowe Price, a mutual-fund company and annuity seller, found that the typical investor needs to hold a variable annuity for 10 to 20 years before paying the extra fees for an annuity starts to make sense.

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• Understand the surrender charges, early withdrawal penalties and annual fees you'll be charged.

• Shop around and compare annuities' features and costs. Vanguard, T. Rowe Price and TIAA-CREF offer low-cost annuities.

• If you're interested in asset protection, consult an attorney who is experienced in this area of the law. Don't take a salesperson's word for how the creditor laws work in your state.

Liz Pulliam Weston's new book, "Easy Money: How to Simplify Your Finances and Get What You Want Out of Life," is now available. Columns by Weston, the Web's most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.

Updated Jan. 4, 2008

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