Too often, buyers of variable annuities simply don’t understand how they work

“I just lost a friend of 20 years when I tried to tell her the truth about her variable annuity,’’ a reader wrote. “She believes her $400,000 investment is guaranteed to be worth $800,000 in 10 years.

“I said she didn’t understand how it works and she said I insulted her lawyer, her ex-husband . . . and the financial planner.’’ Another e-mail:

“I had $100,000 in my account three years ago and wanted to preserve that money. My broker said he had the ‘perfect product’ and told me about a variable annuity that invests in mutual funds and would ‘lock in’ my principal and still give me a chance for growth if the market rose. On his advice, I transferred everything into this annuity. Subsequently, my broker quit his firm. This year, I commented to my new broker that I was glad I’d chosen this annuity because it locked in my $100,000. He looked at me funny, got the annuity company on the phone and they explained my account was now worth $55,000, not $100,000.’’

Many readers violate a cardinal rule by investing in things they don’t understand - and sound too good to be true. Their advisers may not understand the products, either, particularly variable annuities with guaranteed minimum withdrawal or income benefits. These annuities come in many flavors. Some, in exchange for an annual fee, guarantee a return of the original principal, but only after 10 years or so.

For the most part, the basic idea is that, for an annual fee, the insurance companies issuing these annuities guarantee that purchasers will receive a minimum lifetime income, regardless of the actual value of the account.

That’s where the confusion comes in. Insurers base the minimum guaranteed payouts on an amount known as the “protected withdrawal value.’’

Typically, this “protected’’ amount equals at least the principal and may increase by a set percentage each year. Some annuities guarantee that, if there are no withdrawals, the protected withdrawal value will be at least double the original principal after 10 years, even if the actual account value has tanked.

But this protected value is not cash you can take with you. It is simply a number used to calculate withdrawals. To keep the minimum income guarantee, you may withdraw only a small percentage of the protected value each year, such as 5 percent. For example, if you invest $400,000 and the protected value doubles to $800,000, you could start withdrawing $40,000 a year.

Ultimately, you must decide whether the fees are worth it. (They may be if they provide a safety net to invest in the market and ultimately reap higher returns.) If all you want is the minimum guaranteed income, you’d get a higher payout with plain immediate annuities in which you surrender your principal and give up any possibility of gains.

Humberto Cruz can be reached at AskHumberto@aol.com.