We’re seeing a rise in annuity or income products offered as “investment” options in 401(k) plans. While investing with a guaranteed return may sound attractive, many of us should think twice before going this route.
The idea of an income annuity in a 401(k) may have some appeal at first blush because it may offer guaranteed retirement income, or some kind of downside protection on retirement income; however, there are a lot of caveats that you should consider before choosing this option.
The annuity option in the 401(k) is not a generous perk offered by your employer, but rather an attempt by plan sponsors to keep your hard-earned retirement dollars invested with them for the remainder of your life and your spouse’s life.
Outside of 401(k) plans, annuities can offer some tax advantaged savings (along with high fees). An annuity in a 401(k), however, is like buying a tax shelter inside of a tax shelter. There is no additional tax benefit, since the contributions you, and your employer, have made to the 401(k) are already sheltered from taxes until withdrawal.
A 401(k) plan creates challenges for a lay person because they’re expected to be their own pension manager. This works for astute investors, and people who really enjoy this stuff, but it’s common for many to struggle with these decisions. An annuity with a guarantee can seem like a welcome “silver bullet.”
What Does This Really Cost?
While the actual costs depend on what is offered in the plan, let’s take a look at a typical scenario.
If you place some or all of your retirement savings in one of these products in exchange for monthly payments until death there is an implied rate of return that is difficult to calculate, but typically much lower than what you might be able to earn with an otherwise balanced portfolio. In addition to the fees charged, it’s likely that the plan also makes money by investing your money in a portfolio that earns a higher rate of return for them in the long run than what they are on the hook for with you.
But wait you say, “my plan lets me invest in stocks and bonds within the annuity, and I get downside protection.” Maybe, but if you read the fine print, you’ll quickly see this protection comes at a cost that’s difficult to calculate, but results in long term returns that will be lower than if you had invested in the same mix outside of the “annuity option.”
Wait, We’re Still Not Done with Fees
Let’s say that you choose this option, have been investing for years, and are now ready to take your monthly income from the annuity. You’ll have some choices…
Would you like inflation protection? Yes. Ok, we’ll lower the initial monthly payment we quoted you, and adjust for inflation going forward. That’s a fee. If you die, do you want payments to continue to your spouse until their death? Yes. Ok, we’ll lower the initial monthly payment we quoted so that your spouse is covered. That’s a fee. Wait, I’ve thought about this, and want out of this product. Sorry, you’ve been in this long enough that you may have to pay a steep surrender fee. And it goes on.
You Wanted to Leave Something After You’re Gone?
Annuities are ultimately insurance products. Typically, any money “left” goes to the insurance company after you, and maybe your spouse, have left this world. Of course, they used your life expectancy to help calculate what the monthly payment would be. Once you select this option, you’ve exchanged the lump sum for the monthly payments.
To be fair, some plans may allow you an option to leave something to your estate under certain criteria (like you not living so long); however, you guessed it, that comes with a fee.
Many people would do better in the long run by investing in the plain vanilla choices offered in the 401(k) by selecting an appropriate mix of stock and bond funds that align with your age and risk tolerance. The plan should have information to help you make these selections.
If that is more investment stuff than you care to do, many plans also offer target date retirement funds, which naturally rotate from stocks to bonds as the target date approaches. One small issue with target date funds is that they don’t take your risk tolerance into account, so they naturally tend to be more conservative. But, if you were even considering the annuity options, the conservative side may not be so bad.
Another option is to work with a fee only investment advisor, acting as your fiduciary, to develop a financial plan that will create an appropriate allocation that also considers your retirement goals, Social Security, Medicare & ongoing medical costs, and what you might want to leave your heirs.
Please reach out if you have any questions about this topic, or any part of your financial life!
Buoyant Financial, LLC is a registered investment adviser located in Huntersville, NC. Buoyant Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. A copy of Buoyant Financial’s current written disclosure statement discussing Buoyant Financial’s business operations, services, and fees is available at the SEC’s investment adviser public information website – www.adviserinfo.sec.gov or from Buoyant Financial upon written request.