Annuities in 401(k) plans aren't all they're cracked up to be

By Alicia H. Munnell

Emergency expenses are eating up a lot of retirees' money

In any given year, 83% of all retiree households will experience some unexpected expense.

A colleague recently asked me what I thought about annuities in 401(k) plans. Before Harvard reclaims my Ph.D., let me lay out the merits of annuities.

Annuities are contracts that provide a stream of monthly payments in exchange for a premium. The annuity not only protects people from outliving their resources, but it also allows more annual income than most could provide on their own, because the provider pools the experience of a large group of people and pays benefits to those who live longer than expected out of premiums paid by those who die early.

Annuities also protect purchasers against market risk associated with investing in stocks and bonds and make people feel more comfortable knowing they will have regular income to cover their necessary expenses.

That said, my response to my colleague's query about annuities in 401(k) plans was tepid, at best.

First, by design, annuities reallocate money from those who die early to those who live forever. Second, my favorite financial adviser never recommends annuities because they are generally not indexed for inflation. Third, no good studies exist on how in assets much retirees need to hold for emergencies.

The Center for Retirement Research has just released a study on the emergency expenses of retirees. The authors are concerned about the size and frequency of emergency expenditures and people's ability to cover them. They are not really focused on how many people have the assets to buy an annuity once they put aside a reserve for emergencies. Nevertheless, the study's overall findings are interesting, and they do shed some light on the issue of annuities in 401(k) plans.

Also read: I'm only 54 and my 401(k) plan is emailing me about buying annuities. Is this something I should do?

The data come from the 2000-20 Health and Retirement Study and the accompanying 2001-19 Consumption and Activities Mail Survey. Based on these data, the authors calculated how much retired households spend annually on unexpected expenses in three broad categories: "rainy day" expenses related to their home, car and appliances; family-related outlays to parents or children or in response to death or divorce; and healthcare costs, including long-term care.

The results show that, in any given year, 83% of all households will experience some unexpected expense. About 60% of all households will face a rainy-day shock, while 29% will have an unexpected family-related expense and 58% will confront an unexpected healthcare expense (see Figure 1).

The findings also show that these unexpected expenses are significant.

As shown in Figure 2, the typical household is predicted, in any given year, to spend 10% of annual income on unexpected expenses. This number suggests that for a 25-year retirement, the typical household should put aside 2.5 times its average income as an emergency fund. Assuming an $85,000 average income, we are talking $212,500. For the top income group, the percentage of income is smaller (7%), but the income may be $250,000, so the required emergency fund could be $437,500.

The need for such a large emergency fund, combined with the fact that the very wealthy can self-insure against running out of money, limits the potential market for annuities in 401(k) plans.

-Alicia H. Munnell

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03-21-26 1443ET