Wed, 29 Jan 2014
Downside market protection, more retirement spending certainty, and longevity protection are potential benefits of annuities in retirement plans, but they're not for everyone.
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 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?
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.
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 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 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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