Annuity in Your 401(k)? 5 Questions Before You Buy

The SECURE Act, which passed through the House of Representatives a week ago, would make it easier for employers to offer annuities on their 401(k) menus. (SECURE is based on the unfortunately named "Setting Every Community Up for Retirement Enhancement" Act.) The Senate is working on its own retirement bill, called the Retirement Enhancement and Savings Act; Morningstar director of policy research Aron Szapiro discussed the legislation in this video.

Specifically, the SECURE Act would offer employers "safe harbor" for making an annuity available on the plan menu. Currently, employers' obligations as fiduciaries may prompt them to steer clear of annuities in their company retirement plans, as including the annuity serves as a tacit endorsement of the insurer's financial wherewithal and ability to maintain income payments to annuitants. The SECURE act effectively shifts that fiduciary obligation away from the employer and onto the insurer behind the annuity (and indirectly onto state insurance regulators, which must help monitor the financial health of the insurer).

Yet even as that development could make annuities more widely available, it's worth pointing out that annuities already appear on some company retirement plan menus. According a report from the Callan Institute, 8.9% of employers were fielding some type of annuity on their defined-contribution menus last year. That represents a near-doubling from their level in 2015. Annuities are even more widespread in 403(b)s, which are defined-contribution plans for teachers and some nonprofit employers. A 2018 study of large 403(b) plans conducted by BrightScope and the Investment Company Institute indicated that variable annuities contained 24% of 403(b) assets and fixed annuities comprised an additional 22% of the money in 403(b)s.

Is the uptake of annuities a good or bad trend? It depends. Annuities vary widely; some are low-cost and sensible, while others ought to be marked with a skull and crossbones because they're so expensive. Sometimes, annuity owners aren't even aware that they've purchased an annuity. The appropriateness of an annuity as an option within your employer-sponsored retirement plan also depends on your life stage.

If you see an annuity on your 401(k) or 403(b) menu, here are five key questions to ask.

What Is It, Exactly? Annuities are insurance contracts that require the insurance company to pay out the annuitant income, either immediately or eventually. Beyond that, however, annuities vary dramatically, whether inside or outside of 401(k) or 403(b) plans. Before signing on the dotted line, it's essential that you're aware of what type of annuity you're buying.

The most basic annuity type, a fixed immediate annuity, allows you to take a portion of your defined-contribution plan portfolio at retirement and purchase an annuity contract that will pay a stream of income for the rest of your life (and that of your spouse, if you choose a "joint and survivor" annuity). The fixed part means that the payments, once set, don't change, and "immediate" refers to the fact that payments commence right away. The virtue of purchasing such a product inside a retirement plan rather than purchasing it on your own is that you'll be able to obtain "group pricing" on the annuity. In other words, the payout from the annuity may be higher than if you shopped for such a product on your own in the open market.

Deferred income annuities, or DIAs, also offer fixed payments, but they are a bit different in that payments don't commence right away but rather at some point in the future--for example, at age 85--and then continue for the rest of your life. Such products can be particularly valuable if you believe you'll live much longer than average. A study from the Employee Benefits Research Institute found that DIAs were especially beneficial for the longest-lived quartile of retirees. And because the insurance company can invest your money before payments commence, and because not everyone will live a long time after they do, retirees need to put a much smaller sum into a DIA than an immediate annuity to receive the same amount of monthly income.

Variable annuities, which are mainstays on 403(b) menus, differ significantly in that you control how the money is invested. While the account can be converted into a stream of lifetime payments at retirement, the value of the underlying investments, along with other factors such as your age, determine how large the stream of income is. That might sound like an appealing combination, but high fees can erode the gains that you're able to earn.

Equity-indexed annuities, like variable annuities, offer some participation in the market's gains, but with some downside risk protection. In exchange for that protection, the equity-indexed annuity's "participation rate" limits how much of the market's gains you enjoy. In that respect, equity-indexed annuities fall somewhere between fixed and variable annuities.

Do I Need What an Annuity Has to Offer? Annuities are hybrid insurance/investment products. Thus, a key question to ask when evaluating the appropriateness of an annuity in your company retirement plan is to think through whether you actually need the insurance protections at all. If you're early in your investment career and far from spending your money, amassing the largest sum that you can is job one; that means focusing on low-cost investments that give you the most bang for your buck, not high-cost variable annuities. On the other hand, the insurance protections that come along with annuities--specifically, the ability to receive a lifetime stream of income--may be a bigger priority as retirement draws close, especially if you don't have a pension to rely on. At that life stage, the benefits of steering a portion of your plan assets into a low-cost annuity may be greater than when you were younger.

What Are the Costs? Annuities' costs can be either explicit or implicit. In the case of fixed annuities, the costs are generally implicit, in that fees reduce your income payments. Thus, the best way to stay on your guard against high fees with such a product is to compare the payments you would receive alongside those of other products with the same features: plugging in the same dollar investment, whether your income stream will last during your life only or during your life and that of your spouse, your age, the date when the payments will commence, and so on. That way you can see whether the annuity on offer within your employer-provided plan is a better deal than you could find on your own.

Unpacking the cost of a variable annuity is trickier, and fees will generally exert a bigger drag on any returns you earn. Because you are investing in mutual fund-like investment options, called subaccounts, you'll pay fees for their management, just as you would with mutual funds. But you'll pay additional expenses on top of those, called mortality, expense, and administrative fees; those charges may add another 1.5% on top of your subaccounts' expense ratios. Up to 70% of variable annuities in 403(b) plans carry commissions, and surrender charges may apply if you switch out of the annuity before a predetermined amount of time has elapsed. (60% of annuity products in 403(b) plans come with surrender charges.) Those costs have the potential to dramatically undercut your account's ultimate returns.

How Healthy Is the Insurer? No matter the annuity type, it's a contract with an insurance company; it's not FDIC-insured. Thus, your ability to reap a benefit from that contract depends completely on the insurer's financial health. To check up on an insurer's financial strength, turn to an independent ratings agency such as A.M. Best or Fitch. Remember that these firms differ in their methodologies; seek out at least a few high ratings before getting comfortable with the financial health of an insurer.

What Are the Alternatives? Finally, consider the alternatives. If conventional mutual funds are offered alongside annuities on your plan menu and you're not at a life stage where guaranteed income is a high priority, focusing on the nonannuity options is apt to be more cost-effective. And even if annuities are the only choice on your plan menu, you may be able to identify lower-cost, better-quality options among them. Finally, if you've done your homework and found that high-cost variable annuity options are your only choices, consider investing just enough in the plan to obtain matching dollars. Steer additional retirement savings into an IRA populated with low-cost investments; putting your contributions on an automatic investment program will simulate the hands-off ease of a company retirement plan.

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