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Annuities in a 401(k)????
By JLP | February 12, 2008
Interesting article over at SmartMoney.com about annuities in 401(k) plans.
I have my reservations.
Smart Money lays out my main concern:
When choosing among the mutual funds offered within your 401(k), looking at performance and expenses is a clear way to evaluate a fund within its investment category. But things get much foggier when annuities come into the picture.
Knowing the annuity’s return, for example, would come in handy if you were wondering whether it’s a viable alternative to the bond funds in your portfolio. But while all annuity products give you an account of the guaranteed income you’ve purchased so far, figuring out the actual return on your investment is far from easy.
Assuming that you contribute $100 a month starting at age 40 until retirement at 65, Hartford’s Lifetime Income annuity will pay you $5,570 a year for as long as you live. With MetLife’s Personal Pension Builder you will receive only $4,143 a year. But how does that compare with the option, for example, to continue investing in Vanguard’s Total Bond Market Index (VBMFX), which over the past 10 years has returned an average 5.71% annually?
According to Cordaro’s calculations, assuming that you live until age 85, the annuity payouts translate to a 4.5% return for MetLife and 6% for The Hartford. (With either policy, returns increase the longer you live.) The Hartford’s return is quite reasonable, given current bond returns, he notes, but that’s not the case with MetLife’s product. “What’s needed is a way for participants to do the same comparison,” he says.
My other concern is expenses. In general 401(k) plans should have pricing power and therefore should be able to get products with lower fees. However, according to the article, there’s still some pretty high fees attached to some of these products:
As you approach retirement, a guaranteed minimum return may be beneficial since you won’t have to worry about your portfolio shedding 10% or more right before you retire. (Read our story for more on the dangers of tapping your nest egg in a bad year.) But it’s unnecessary when you have a longer time horizon and, therefore, the chance to reap bigger market gains. “If I had 10 or 15 years to use that money, the chances that it’ll grow by 5% or less annualized over that period is extremely small,” says Steven Podnos, a fee-only financial planner in Merritt Island, Fla. “You can take insurance [that it doesn't], but you’ll pay for it.”
Those additional expenses eat into your returns. Prudential’s Income Flex, for example, has an expense ratio that ranges from 1.5% to 2%, while Genworth’s product charges 80 to 90 basis points for the income guarantee, on top of underlying fund expenses. And should you decide to get out of these investments if you’re not happy with the performance — or simply leave your job and roll over your account to an IRA — you will have paid those additional costs for nothing.
Remember, those fees are ON TOP of the underlying fund expenses. I think most people can do better by diversifying and keeping expenses low.
More on this discussion to come later.
Topics: 401(k), Retirement Planning | 8 Comments »
February 12th, 2008 at 6:53 am
Name isn’t everything either. The core investments in a TIAA-CREF account are technically all annuities (variable annuities) which to the casual eye aren’t distinguishable from similarly constituted mutual funds. And they have reasonable expenses, although they have gone up recently because of a bad corporate technology plan.
February 12th, 2008 at 9:10 am
I saw a story talking about this in one of the financial trade magazines this month, and it made me stop and think. Clearly, someone can do just as well and structure a portfolio without the annuity and save on some expenses, but the bottom line is that some people (especially some jaded baby boomers) want that guarantee for life. It doesn’t matter that it costs more or the internal rate of return might be lower than they could get by doing something else, but they just want to be guaranteed a monthly check for the rest of their life.
And when there are participants without pensions who are demanding some sort of benefit like this, plan sponsors are going to be more than willing to offer it.
In my opinion, it isn’t the idea of adding an annuity benefit that is the problem, but the implementation of this feature. They are pushing the annuity option as basically one place to put new contributions each paycheck, where it then stays and grows until retirement. Why? Why not let people invest their funds like they normally would without the fees and low returns during their working years and instead offer the option to annuitize their entire, or a portion of their benefit when they retire?
This seems like a win-win to me. The employee benefits from having total control over their investments while working and can then lock in income for life when they retire, and the insurance company still gets their payday in the form of an immediate annuity. Of course, they stand to make less money since they would surely rather collect over 1% each year for 30 years than a one-time 4% or similar fee at the end.
February 12th, 2008 at 9:25 am
By far the biggest draw of these plans is the guarantee part. In an uncertain world were no portfolio is immune from the whipsawing of the market, a fixed income return makes a nice addition to a diversified portfolio. Putting an annuity inside a 401K is definatly overkill; considering many 401K plans pass on expenses to the participants and then to pay annuity fees on top of that is a little too much. I’d only look at the annuity outside of a 401K plan.
But hey, $100 month is peanuts, if you’re already diversified in stocks, bonds, MMs, Real Estate I’d consider setting this up and letting it grow for 25 years.
Of course I have a insurance license, I could buy this and pay myself a commision..takes care of pesky those fees.
February 12th, 2008 at 10:05 am
I’ve never been a fan of annuties at all. With the recent market pull-back the insurance companies are simply preying on the fear of the average Joe.
In a properly diviersified portfolio, there is no need to add on the excessive fees of annuties.
I’d prefer to buy great dividend paying stocks while they are on sale and offering above average yields.
February 12th, 2008 at 10:35 am
Many years ago a magazine cover read “Annuities Suck.” While nothing is ever that clear, holding an annuity within a 401(k) plan is a fairly obvious bad idea. It’s particularly so during the accumulation (saving) phase of life.
All the extra fees are not worth what amounts to redundant tax deferral. Then, consider that the insurance companies would still be happy to annuitize your assets (likely higher, thanks to lower fees and better performance) at retirement. Keep your options open now and pay the least you can for the best expected performance. When you get closer to retirement, reassess. Nothing is locked in.
Well, an annuity with a huge surrender charge might be. Why do they do that? Think about it.
February 12th, 2008 at 2:23 pm
Another problem is that most people don’t actually retire at their company, so when they liquidate their 401K investments to execute their rollover, I have little doubt that they get screwed by the usual silliness that insurance companies charge when you get out of something.
I’m not normally a big fan of regulation, but few employees and few HR managers have a clue about what constitutes a good 401K plan. And the consequences of a bad 401K plan are profound enough that the taxpayers has a legitimate interest in seeing that they’re done reasonably well.
February 13th, 2008 at 8:57 am
Great post and comments. Right on the money. There is no reason to have an annuity in a 401K plan. The extra fees (and surrender fees if an employee leaves or the plan changes before surrender fees are through) kill returns.
If someone wants an annuity at retirement, then they can roll the 401K to a fixed annuity.
This movement is nothing more than the insurance companies trying to justify slamming folks with fees.
February 21st, 2009 at 1:43 pm
Perhaps these comments should be revisited with the recent market downturn. I wonder if anyone’s conviction on this topic has changed.