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By rights, variable annuity marketing departments should be licking their lips at the UK retirement arena. A huge increase in the number of retiring investors with a burgeoning pool of pension savings sounds like the basis for a perfect business plan.

To make matters even more tempting many investors do not like the most commonly used retirement option and annuities. To cap it off, a turbulent stock market is causing sleepless nights for some investors in drawdown. What could go wrong?

Well, two years since they first were heralded, we are still waiting for the predicted US invasion to get past the shores. Why? In part it is because the existing options have enjoyed some good fortune and have become more favoured by advisers and their clients.

Annuities have been one of the few beneficiaries of the credit crunch as companies have seen yields and spreads soar as market liquidity dries up. Added to this a fierce price war has seen insurers vie with each other to grab the coveted annuity “top-spot.” This has seen rates hit a six-year highpoint with some rates increasing by almost 15 per cent in the last three years.

Meanwhile, the rapid rise of individual annuity pricing with enhanced and post code annuities has allowed many retiring investors to enjoy an even bigger retirement income. Last year, enhanced annuities breached the £1bn mark and enhanced company results suggest 2008 will be another bonanza year. Unsurprisingly, some investors have found the haven of annuities a welcome relief from the rigours of the stock market.

Many drawdown investors continue to benefit as costs tumble to make it a far more commoditised contract, thereby making it much more affordable and accessible. Legislation has helped drawdown’s popularity as investors find just accessing their tax-free sum and/or the complete income control attractive options.

A 25 per cent market share of 2007’s maturing pension funds is testament to how mainstream it has become since its launch 13 years ago. A sizeable number of investors are using drawdown as a means to access some money today, but are leaving the rest invested to recover, should the market do so. Most intend to annuitise by their 70s as they are well aware that deferring purchasing an annuity may increase the standard rate available. Many are also aware that later life frequently brings with it medical conditions that may qualify them to a much higher income through an enhanced annuity.

Clearly, unless third-way products can offer a better alternative to what is currently available, they will remain largely unloved and unused. However, increased competition from existing retirement solutions cannot fully explain why Watson Wyatt has damned variable annuities with faint praise by projecting it to have a maximum market share of a meagre 5 per cent in 2017. This is hardly the stuff to fuel the American Dream and is unlikely to generate sufficient profit to make it all worthwhile. Tellingly, with profit and unit-linked annuities are predicted to have a larger market share than third-way annuities.

The claim that it is a new concept and as such needs time to be accepted is starting to wear a bit thin. As we have seen, income drawdown has rapidly become an everyday retirement solution. I am increasingly hearing one voice – that the current raft of plans are just not that liked. Perhaps those insurers offering these plans might like to say publicly how many plans were written in 2007 and this year to date.

There are a number of compelling reasons why these plans have failed to make that much of an impact.

In terms of costs, it is commonsense that the more bells and whistles any product has, the greater their eventual cost to the consumer. Variable annuities have to contend not only with administration, investment and advisory costs, but the additional substantial layer of guarantees.

All of these expenses may well be justifiable, but when added together may make the contract unfeasible overall. At some point, the high initial and ongoing outlay will remove the likelihood of the investor realistically seeing any benefit. These plans can cost upwards of 3.5 per cent a year. If 5 per cent a year income is being taken, an annual return of 8.5 per cent simply to stand still is a staggering investment hurdle for retiring investors to bear.

In fairness, I do not think these insurers are overly charging for the guarantees they provide – quite the contrary. Recent meetings with hedge fund managers suggest that they think the real base charge for these types of guarantees is likely to be in the region of 1 per cent to 1.5 per cent a year. The credit crunch and events of the last few weeks are driving these hedging costs higher still as their cost is partly determined by the future anticipated volatility of the particular assets. Given the huge swings in share movements around the globe, the current charge may actually have to be increased or the insurers will have to be prepared to absorb them.

The variable annuity response to this criticism that it is all ‘smoke and mirrors’ has been to reduce the expense of the associated hedging that underpins the guarantees in some way. Insurers have largely achieved this by limiting equity exposure, offering a range of equity weighted packages or by capping investment returns. Neither of these options stands scrutiny. Assuming that recent world events don’t spell the end of capitalism, over the medium term equities typically provide the highest returns of all assets. Over the last 50 years equities have returned an average annual real return of 7.2 per cent; gilts at 2.4 per cent and cash just 2 per cent. Limiting equity exposure will reduce costs, but will typically reduce returns.

Unless the plan’s charges make it feasible to invest predominantly in equities, investors may be prudent in steering clear altogether. If an investor is going to incur the additional outlay of a guarantee, it follows that they should seek to maximise future potential returns by investing more aggressively than they typically would. Surely, the guarantee is there to be used?

A cap on future returns is similarly not in investors’ interests. Equity markets tend to be of a steep, rollercoaster nature. The FTSE 100 has given a return of 10 per cent or more, 14 times out of the last 20 years. Raising the investment hurdle to years where there has been a return of more than 15 per cent will still have seen the FTSE clearing the bar 11 times in the last 20 years.

Some providers are offering tracker funds as a way of reducing the investment cost. However, index funds will mean certain under-performance – adding in an additional layer of expenditure to the management charge and tracking error will simply serve to exaggerate this for no purpose to the investor. The demise of Lehmans and the US government’s bail out of AIG has shown just how complex derivatives and hedging are. Variable annuity’s guarantees are underpinned by such investments.

Investors may find it unsettling that Aegon, Hartford and MetLife have issued statements in recent days confirming such exposure to both Lehmans and AIG. As these contracts can last for 30 years plus, can IFAs and their clients have absolute confidence that all guarantees will last the course? Things may be fine, but it will undoubtedly cast a doubt in investors’ minds. The announcement from Old Mutual that they are having to make additional provision of $150m after a hedging mistake left them exposed to falling markets may eventually seem like loose change.

All of this will further delay widespread acceptance of variable annuities as a mainstream retirement tool. The continuing deafening silence of UK insurers launching their own versions tells its own story.

In reality, today’s retirement landscape seems not to have changed markedly in the last few years. Third-way annuities have suffered from a false dawn – promising much, but remaining on the sidelines. Meanwhile, many of today’s retiring investors are securing the pension solution that variable annuities claim to provide - a secure minimum income for life, while leaving a portion of their pension savings still invested in the markets. Mixing and matching between ordinary annuities and drawdown does just that, at a fraction of the initial and ongoing costs associated with the current crop of plans.

If variable annuities are to play more than a peripheral role, they need a major makeover.

Nigel Callaghan is a pensions analyst of Hargreaves Lansdown