Advantages and Disadvantages of Annuities in 401(k) Plans

By Christine Benz and Daniel V. Farkas | 01-29-2014 11:00 AM

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
It's 401(k) Week on Morningstar.com. Joining me to discuss the role of annuities in
401(k) plans is Daniel Farkas, a senior investment consultant with Morningstar
Investment Management.
Daniel, thank you so much for being here.
Daniel Farkas: Thank you, Christine.
Benz: Daniel, I know that sometimes investors have annuities in their 401(k)
plans--they're often not even aware that they're there. Let's talk about the key
ways that annuities can be woven into 401(k) plans. There are a couple of different
ways that annuities might present themselves. Can you talk about that?
Farkas: There are two primary ways that an employee might find annuities in
their 401(k). One is as a stand-alone investment option, alongside plain-vanilla
mutual funds. This would be an investment product that confers real insurance
benefits to the participant in the form of market protection, guaranteed lifetime
withdrawals, and the ability to annuitize in retirement.
There is a second one, which is kind of this group annuity wrapper that an entire
401(k) can be so-called "wrapped" in. These are very different; they're totally
different animals. They confer basically no insurance benefit to participants, and
something to look out for is that they often have higher fees. Fortunately, they're
becoming less of an issue in the 401(k) space, but totally different characteristics,
despite the similar names.
Benz: If someone is looking at their 401(k) menu, trying to evaluate the choices,
how do they even know that there is an annuity in the mix? Should it be clearly
labeled that it's an annuity? I sometimes talk to people who have annuities and
really aren't sure what they have.
Farkas: I like that question, because the answer to that should be really simple,
and I don't think it is as simple as it should be.
One thing you can do right off the bat is certainly look at the names of the funds
and look for things like "guaranteed income," "lifetime income," things that
connote the types of properties that these products give people. But that's
certainly not the end of the story, because there are other funds in your lineup
that will have the word "income" or "lifetime" in them.
You can look at the investment category under which they're listed. When you log
into your account, funds will be listed under categories, such as large growth, large
blend, while an annuity product typically would be in its own category, and the
name of that category could be whatever the record-keeper calls it, but hopefully it
will be something that demonstrates to you what is under the hood.
Then, you can certainly click on funds. There should be a one-page description of
the fund. You can look at the prospectus, in which you should be able to tell, and
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Farkas: They do. When 403(b)s were established in the '50s, the only allowable
investment options were annuities. That changed in the '70s; that restriction was
lifted, and regular mutual funds can now be in 403(b)s. But inertia is strong, and
the people who sell the annuities to these tax-exempt organizations' 403(b)s really
have their foot in the door. Today, reportedly more than half of 403(b) assets are
still in annuities, which is obviously much higher than what you find in 401(k)s.
Benz: If you see an annuity option in your 401(k) or 403(b) plan, how do they
work? And how might they be different from the traditional plain-vanilla mutual
fund options?
Farkas: I'm going to speak in generalities here because every product is different,
but they are converging to a standard. In general, they are variable annuity
products with a GLWB rider--a Guaranteed Lifetime Withdrawal Benefit rider.
They have basically two phases; they have an accumulation phase and a
decumulation phase.
During the accumulation phase, you are close to retirement, but not there yet
generally, and you are adding money into the annuity, and you're invested into
investment options that the insurance company makes available to you. They're
pretty restrictive in terms of what you can invest in generally; they're generally
index equity and bond funds to try to keep expenses down, and the allocations are
set by the insurance company. They don't want you taking too much equity risk
because it actually would make it more expensive for them to hedge, and again,
they want to keep costs down.
Benz: So you have the annuity option. Then are you able to pick the investment
choices that would be under that hood, or is that done for you?
Farkas: In these products, you typically do not have much option in terms of how
you're investing the assets. There are some other variable annuities outside of the
space where you do have optionality, but these products you typically don't.
But it's during this period, that you start to get the first benefit associated with
these products, and that is market protection, essentially. What the insurance
company will do is, each year they will look back at what the balance is in your
account. And if it's gone up, they will ratchet up what's called the benefit base, and
that benefit base is what your ultimate annuitization is based on. That base can
never go down.
the companies should be educating you on what the options are in your plan.
Benz: It's a pretty different animal. You think it should be broken out and labeled
pretty differently when people are looking at their plans?
Farkas: I do think it should be, yes.
Benz: I'd like to discuss one area where annuities tend to be more prevalent;
that's in the 403(b) market. Can you give us a little bit of history on why this is
the case? And do 403(b) participants today tend to see a lot of annuities in their
plans?
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So, if the next year, the market tanks, and let's say your balance went from
$50,000 one year to $80,000, and then back down to $50,000, your benefit base
would still be $80,000. When you annuitize, it would be based on that $80,000.
So, there is some market protection during the accumulation phase.
When you're in retirement, you go into the decumulation phase, you annuitize. At
that point, the payout rate is based on what the insurance company is offering at
that time and your age, a certain percentage of your benefit base is then promised
to be paid to you over the rest of your life at a set amount.
So, a couple of key things to be aware of there are--the payout rates change over
time with interest rates. I think one of the reasons that these products have not
taken off that much so far is because people are wary of locking-in what they think
might be
Benz: a low interest rate relative to historical norms.
Farkas: Exactly. So, that's one thing to be aware of. People are probably timing in
the market. Whether they're doing it well or not, we'll find out.
Then the other thing is your age--the longer you wait the higher the payout rate
would be, similar to Social Security. These typically have five-year ranges. So,
between ages 60 and 65, the payout rate would be maybe 4%, for example, and
then it might go up to 4.5% over of the next five years. So, that's typically how
they work.
Benz: You've touched on some of the benefits--a back-stop against down markets,
some guarantees when you are in the decumulation phase. Are those the key
advantages in your mind when you think about these products and the role that
they might fill in someone's retirement plan?
Farkas: I would say the key advantages would be the market protection that we've
talked about. Then, another kind of advantage for these type of products is that,
the industry has done a good job in recent years of improving the saving part of
the 401(k) balance sheet. Auto-enrollment has gotten more people involved;
auto-escalation has gotten people to save more. I think investment options have
gotten cheaper. We have gotten target-date funds used a lot; that's great. But the
spending side of things needs work.
Relative to not having insurance, this is partially a spending program. You know
what your income for this annuity will be for the rest of your life and that's your
spending program. So, that's another benefit.
Then lastly, related to that, there is an element of longevity insurance embedded
in this. One of the greatest risks in retirement is running out of money because
you live longer than you thought you would, and once you annuitize, these
payments are guaranteed for life. That's partially going to get longevity insurance.
There are separate products that are pure longevity insurance products that don't
have some of these other bells and whistles and are just getting at that, and those
would pay out higher rates. So, it's not pure-form longevity insurance, but there is
an element of it there.
Benz: Anytime people hear variable annuity, they think high costs, or there can be
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high costs, and also complexity. But let's discuss the whole array of what you
perceive as potential disadvantages with this product type in 401(k) plans?
Farkas: Any insurance product is going to have a negative expected value.
Benz: What do you mean by that?
Farkas: I mean that on average you are going to have been better off if you didn't
buy the insurance; that's the case for these products. That is the case for health
insurance, life insurance, any insurance that's priced properly by the insurance
company. They are a for-profit entity. You are, on average, going to be better off
not purchasing it.
Benz: But there will be winners and losers, right?
Farkas: There will be. And you don't purchase it for the average. You purchase it
to avoid the really bad situations. And it's the same thing with hazard insurance on
your house. You're OK if your house never burns down and you never reap any
benefit from that insurance, because you were protected against the really bad
thing happening, and that's the same thing here.
So, they are expensive, but you are getting real benefits for them. And I think you
need to evaluate as a potential buyer of these, whether you are someone that is in
the target market to reap the benefits that I just discussed. So are you someone
who really needs market protection, which is, are you close to retirement?
If you are 30 years from retirement, I think it's hard to make a case that you
really need that market protection. You might be paying for something that you
don't need.
Benz: Is there any advantage to purchasing such a product early in one's investing
career versus waiting until later, when that market protection might have a
greater sense of importance for you?
Farkas: I would say to get the market protection and to pay the insurance fee for
decades before retirement probably just does not make sense. Now it's worth
mentioning that some of these products are set up with a third stage that I didn't
even talk about. It's actually before the accumulation stage, and it's kind of a
placeholder. So, you can invest in a target-date series that is not an insurance
product per se, but it's set up to collide into the accumulation phase at a certain
age.
And so that could be something that would make sense to invest in at a younger
age. If you just want to know that you are set up to be in an annuity at a later
age, you're not paying the insurance until you actually move into the accumulation
stage. But that's really the only circumstance in which I could see doing it at a
young age.
Benz: Do you think things will move more in that that direction, where someone
will have that option within their plan versus the way things are set up now?
Farkas: They already are.
Benz: I know there are other considerations, other potential knocks on annuities
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within IRAs or 401(k)s. One thing I often think is that maybe you're doubling up
on tax advantages--that annuities themselves have some tax advantages, as does
your 401(k). Is that an issue, in your mind?
Farkas: It is. It's something to consider. Annuities are tax-advantaged. The gains
in the portfolio are tax-deferred. Every asset in your 401(k) is already
tax-deferred, so you're not getting any extra tax benefit from owning it in your
401(k). If you have sufficient assets outside of your 401(k), and if you're able to
strike a similar deal in terms outside of your 401(k), there could be a benefit to
buying something like this with non-retirement assets and expanding the scope of
assets that have this tax benefit [in your 401(k)].
I would say that a lot of times, 401(k)s are able to get institutional pricing, and
you might not necessarily find that you are able to get the same deal on your own.
Benz: It's obviously a very complex area. Do you have any tips on how to conduct
due diligence? Any places that investors should go if they want to research the
annuity options in their 401(k) plans? Any thoughts on how to do your homework?
Farkas: People don't like looking through prospectuses, but I really think,
especially with something that people are less familiar with and that are new, it
would be a good idea to read all that you can about these investment options from
what the company provides and what you can see in the prospectus.
I think some things to look for would be, obviously, costs. If you're comparing two
annuities with each other, look at the costs, and try to do apples-to-apples to try to
look at two different programs that are offering similar types of benefits. Costs
include the underlying fees, administrative fees, everything together--all the
costs--comparing one to another.
Certainly look at payout rates. Those differ across the different firms. Different
firms offer different payout rates.
Benz: And will that be clearly expressed, or will I need to wade through some sort
of complex calculation?
Farkas: That should be pretty clearly stated. There would be different age ranges
with different payout rates, and that can differ whether you are doing it as a single
person or if you want a joint rider, so that your spouse could continue getting
these benefits as you die. Of course the payout rates will be lower if you select that
option.
Then another thing I would look at would be the financial strength of the insurance
company. These are not guaranteed by the government. They are guaranteed by
one or more insurance companies, and these are very long-term contracts,
hopefully. You can get information pretty easily from rating agencies on the
financial strength of insurance companies, and the higher the better.
Benz: Daniel, thank you so much for being here. Obviously a very complicated
area, but we are glad that you could provide some clarity.
Farkas: My pleasure. Thank you for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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