Variable Annuities: Spend Assets And Donít Run Out of Money

Robert D. Lipsey, CFA, ALPA Retirement and Insurance Department
Air Line Pilot
, June/July 2005, p.24

For most people, providing for retirement means accumulating some amount of money by their retirement date; however, they give less thought to the stream of income that the accumulated savings will provide after retirement. This, in most cases, is the primary issue. Variable annuities may in many cases be the best solution to this problem.

During the 1950s, the pilot groups of many ALPA-represented carriers bargained for a combination of retirement benefit vehicles--defined-benefit plans (A Plans) involved fixed annuities for the life of a participant, and defined-contribution plans (B Plans), normally a variable annuity, provided a stream of payments for life. Both types of plans allowed for a surviving spouse or other contingent beneficiary to receive payments after the retiree died.

Few of these plans remain in existence today in their original form. The first to go at most carriers were the variable-annuity features of the B Plans--either as most commonly used or even as available options. B Plans had begun as variable annuities because this form of benefit allowed beneficiaries to spend the principal they had accumulated at retirement over their life expectancies without the risk of running out of funds as a result of living too long. At the time, the need for an individual to use his or her accumulated principal was fairly necessary. Long-term government bonds during the 1950s yielded an average of 2.7 percent, and short-term treasury bills averaged about 1.9 percent. If one assumed (1) an accumulated principal value of $1,000,000, (2) a 2 percent annual return over oneís lifetime, and (3) a single life expectancy of 20 years at retirement, then the use of interest and principal would produce an annual annuity of $61,156 per year. By contrast, the use of interest alone would amount to only $20,000. 

The difference in income was fairly dramatic. What would happen, however, when a retiree outlived the 20-year life expectancy? No problem. Someone in the annuity pool would have been kind enough to die young. No one knew how long he or she would live, but for large enough groups, the averages worked pretty well. And therein lay the problem. For averages to work, all participantsí assets needed to revert to the pool upon their demise, leaving no estate to pass on to oneís offspring. Still the answer seemed obvious. The difference between $20,000 and $60,000 per year was big. In many cases, spending principal was a necessity.

During the decade 1975-1984, long-term government bonds yielded an average of 10.3 percent. In this environment, $1,000,000 would generate $103,000 per year using interest only. The 20-year, single-life-only annuities would generate about $120,000 per year. The percentage differential was nowhere near as great, and those who selected the interest-only option could leave an estate of $1 million.

Pilotsí defined-contribution plans were renegotiated. Lump-sum payments became options on retirement. New plans did not offer a variable-annuity option. Unfortunately, the interest rate environment of the late 1970s and 1980s reversed again. The effect can be seen in the following income comparison for bonds vs. variable annuities under different interest-rate scenarios:

$ Annual Payment Per $1 million

And 20-Year Life


Bond Fund   



Variable Annuity   



Bond Fund   



Variable Annuity   



Bond Fund   



Variable Annuity   



Bond Fund   



Variable Annuity   


Clearly, interest rates have a considerable effect on the need for variable annuities. Common opinion seems to be that interest rates will go up from here, but no one knows with even the slightest degree of certainty. Between 1926 and now, long-term government bond yields have varied between 1.6 and 13.6 percent (on an average annual basis). They first went above 5 percent in 1967. While we still seem to be anchored in the experience of the 1970s and 1980s, the new millennium will involve its own issues. One new factor will be the retirement of the baby boomers, which may very well push interest rates down.

And speaking of interest rates, what about the defined-benefit plans (A Plans) mentioned at the beginning of the article as being part of the retirement packages? They seemed to keep the total retirement income high despite reduced interest rates. Unfortunately, funding for A Plans assumed strong equity returns and high interest rates. The turnaround of high-equity returns after 1999 and the lower interest-rate environment did them in. So what hope is left if interest rates go down and stay there?

Retail variable annuities

Fortunately, a provision in the Internal Revenue Code has kept retail variable annuities alive and well, and they remain widely available today. These variable annuities generally involve two phases.

Variable Annuities Adjustments

The adjustment is normally made as follows:

                                    1 + actual investment return
Annual payment ◊ --------------------------------------- =
1 + assumed investment return

An actual example of the above process is as follows:
1. $1,000,000 initial principal
2. Payout option--75 percent spousal (or other contingent annuitant) payment
3. Age of annuitant--60 years
4. Age of contingent annuitant--58 years
5. Assumed investment return--3.5 percent
The initial annualized payment would be $52,920 per year versus $35,000 from a 3.5 percent interest-only payment. If the actual investment return on the fund(s) that the $1,000,000 was invested in averaged 7 percent per year (instead of the assumed 3.5 percent), the payment would be increased by 3.38 percent per year. If the actual return averaged 0 percent per year, the payment would decrease by 3.5 percent per year. If the $1,000,000 was invested in a stock fund that suffered a negative return of 50 percent in 1 year, that $52,920 payment would decline as follows:

$52,920 ◊ ---------- = $25,689

If the market increased by 50 percent:

$52,920 ◊ ---------- = $77,067

Clearly, volatility in invested return is a very real (rather than an academic) measure of investment risk when using a variable annuity, and so, investments should be reasonably conservative.

The first is an accumulation phase in which annuity customers make after-tax contributions to annuities. The taxes on investment earnings are deferred until funds are withdrawn. These funds may be withdrawn, and taxed, at the end of the accumulation phase. The withdrawal may be total or partial over time, without entering an annuitization phase. This is what most annuity purchasers have done to date.

The next phase--the annuitization, or spending, phase--is really the subject of this article. By entering this phase, a participant irreversibly joins an annuity pool. This enables the participant to spend principal over his or her expected lifetime without the risk of running out of money by outliving that life expectancy. In fact, one need not participate in an accumulation phase but may enter directly into the annuity phase with either pre-tax or after-tax savings from almost any source, e.g., a 401(k) plan. If the purchase amount involves pre-tax money, the annuity payments are taxable as ordinary income. If the annuity is purchased with after-tax money, the portion of the payment that constitutes a return of principal is tax-free. The decision to enter the annuitization phase cannot be reversed.

The mechanics of retail variable annuities in the annuitization phase are straightforward. The purchaser chooses the following: the amount to be annuitized; an investment vehicle (usually a fund of fixed-income investments, equities, or both), which is a part of the providerís investment-fund family; an assumed investment rate of return (normally 3-5 percent); and a payment option, (e.g., single life, 50 or 100 percent, joint and survivor, 10-year certain and life thereafter, etc.).
The annuity provider then calculates an initial monthly payment, based on the age of the retiree (and spouse, if applicable). The calculated payment is then paid to the retiree for that personís lifetime--and the other personís lifetime thereafter, based on the payment option chosen.

At regular periods, however, the payment is adjusted based on how the investment actually performed compared to the assumed rate. If performance is equal to the assumed rate, the payment remains the same. If it differs, an adjustment is upward or downward (see sidebar, left).


Variable annuities can involve considerable expense. The expense ratio of investment funds used must be considered, as well as administrative charges called M&E expenses. In some cases, the total can be as high as 3 percent per year. This means that a fund would have to earn a 6.5 percent before-fee return to keep the payment level in the example that used a 3.5 percent assumed return. Brokerage commissions (loads) can also apply. Furthermore, some states charge premium taxes on variable annuities.

While ALPA does not endorse or recommend any variable annuity provider, my personal suggestion would be to take a look at Vanguard, which has no loads and whose expense ratios and M&E charges are among the lowest.


Variable annuities may not be for everyone. They involve extra expenses and the depletion of oneís estate. Tax considerations may also be involved. For a retiree who needs to spend some principal, however, variable annuities may make good sense for all or a part of accumulated savings.