Why Annuities Belong in 401(k) Plans

Overly Prepared No, I have not received payments from the insurance industry. (Not even holiday candy, such is the pity.) Bear with me on this one. First, a basketball story.

By NBA rules, a player must leave the game after committing six fouls. This does not often occur. So far during this year's playoffs, only six of 320 starters have accumulated six fouls. That 2% failure rate overstates the danger, because it is inflated by the most aggressive players. Those who are more careful face little risk. For example, in 1,205 career games, Hall of Famer Wilt Chamberlain never fouled out.

Despite the odds, NBA coaches typically remove a player in the first quarter if he receives two fouls, and then bench him for the rest of the half if he receives a third. That is--to protect against the possibility that the player might later be unavailable, they ensure, absolutely and positively, that he is immediately unavailable. In a competition where a basket made in the first quarter counts for as much as one scored in the fourth, that logic is ... dubious.

In critiquing that tactic (albeit more gently than I would have done), a basketball writer named Ben Falk pinpointed why coaches act so conservatively. "In certain situations it seems that people irrationally prefer keeping their options open even when there's a clear, superior alternative. We like the idea of flexibility and don't want to close doors. When a player fouls out, a coach has a door closed: they no longer have decision-making flexibility."

Bingo, Mr. Falk. That leads to our topic at hand.

Perceptions Matter As discussed in this column two weeks back, annuities have several marketing problems. Their costs are usually too high and always insufficiently reported. Their name is off-putting. Perhaps worst of all, they remove the investor's control. Before purchase, the annuity customer owns a bag of gold (metaphorically speaking). Afterward, he holds only a set of promises. If he subsequently decides that he would prefer something else for that money than those promises, he is out of luck. The decision is irrevocable.

In a recent Gallup poll, 85% of pre-retirees stated that they needed more guaranteed monthly income than Social Security could provide, but only 27% were willing to give up access to their assets to accomplish that feat. While the query was leading (who wouldn't want more guaranteed income?), the disconnect is real. People seek guarantees but also control.

But not always. Social Security provides guaranteed income without control and yet is highly popular. (In the most recent Pew survey, only 10% of Republicans and 3% of Democrats supported spending cuts to Social Security, which made it the second-most-popular government program after veterans' benefits.) Ditto for traditional pension plans. It turns out that people are quite happy to relinquish their money in exchange for a future income stream, as long as the exchange is framed properly.

The Gradual Approach This raises the question: What makes annuities a tough sale and Social Security/pensions an easy one? As previously mentioned, some of annuities' problems are self-inflicted. Nobody forced the industry to be secretive and to develop a reputation for offering products that are sold rather than bought. But it is not responsible for the psychological barrier. That occurs because of annuities' structure: They ask for wealth that already exists. In contrast, Social Security and pensions quietly nibble on earnings as they are created. Far less painful.

When framed this way, the way forward is obvious. Just as Social Security builds a retirement-income foundation by garnishing an employee’s wages and defined-benefit plans supplement that base by operating similarly, so should 401(k) plans ease the trepidation of annuity purchases. Instead of holding only mutual funds, employees could place some of their contributions into a deferred income annuity. Just as with Social Security and pensions, those drip-by-drip contributions will eventually become meaningful sources of retirement income.

From Theory to Practice I am not the first person to think along this line--although almost certainly the only one to do so while reading an article about NBA coaching strategies. As it turns out, several insurers offer such products. For example, TIAA sells TIAA Traditional, which "guarantees your savings will grow at interest at a set rate and can pay you income for life after you retire."

So far, the marketplace hasn’t been biting. The mutual fund habit dies hard. In addition, as Morningstar’s David Blanchett points out, there are drawbacks to deferred income annuities. First, as they are lower-risk investments than equity mutual funds, they also figure to have a lower long-term rate of return. Second, there is such a thing as over-insurance; wealthier retirees may end up preferring a lump sum to guaranteed income. Third, deferred income annuities won’t please employees who wish to tap into their 401(k) balances before retirement.

The first disadvantage must be acknowledged. In exchange for receiving an income guarantee, as well as the benefits of "mortality credits" that are created by shared insurance (as opposed to self-insurance), the expected return for deferred income annuities is indeed less than that of stocks. Such is the nature of diversification. As with other investment decisions, prospective annuity owners must balance their desire to accrue more wealth with their desire to reduce risk. For most, deferred income annuities will not be the only solution.

The remaining two issues can be addressed, however, by giving 401(k) annuity owners reasonable opt-out terms, wherein they can convert their projected income stream into an immediate lump sum. That can’t be permitted with retirees’ annuities because any annuity owner whose health faltered would quit the program and collect the check. However, the option could work for the younger policy-owners that would come through 401(k) plans. (Perhaps up to age 50?)

Just preliminary thoughts. The details, as always, cannot be fully anticipated. The point is that annuities belong in 401(k) plans. Not as they previously have been pitched--as a different version of a mutual fund, aka “variable annuities”--but instead in their purer form, as a source of guaranteed income. Putting annuities into 401(k)s sounds silly, given the industry’s notoriety. But it makes investment sense.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.