Target-Date Funds With Annuities Are Gaining Ground. Is That Good for Your Retirement Plan?

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Guaranteed income and retirement sound pretty nice, but what are the trade-offs to make it happen? Several big asset managers offer target-date funds with built-in annuities. However, it’s difficult to compare one against another because their strategies tend to differ, and retail annuities’ dubious reputation has set up a hurdle for mass adoption, but recent important developments could clear the path for these funds to appear in 401(k)s and other retirement plans. New Morningstar research explores why target-date funds with annuities are gaining ground in the US. Jason Kephart has dug into the data. Morningstar’s senior principal of multiasset manager research is here to explain what he found. It’s good to see you, Jason.

Jason Kephart: Thanks for having me.

Hampton: Of course. What are annuities and what are they designed to solve?

Kephart: They’re insurance against living happily ever after. I think for most people in retirement, the challenge is you really don’t know how long you’re going to live. And so, being able to kind of budget your spending over that uncertain time period is very difficult and gives people a lot of stress and anxiety. Annuities are kind of designed to give you that insurance of a guaranteed paycheck as long as you’re living.

Hampton: Why has this retirement planning tool gotten such a bad rap?

Kephart: Yeah, it’s got a pretty bad rap. It’s kind of funny. It’s almost like it’s a four-letter word. Some of these target-date providers won’t even say the “A” word when discussing their series, but I think it’s mainly because they’re complicated. There’s not a lot of flexibility for some of them. Also, they can be very expensive. I think if you’re buying them outside of a 401(k) plan, there are things like commissions that really eat into your kind of income. And I think most people just think of their shady brother-in-law trying to sell these things. It’s very much about something that’s sold, not bought, and they can get very, very complicated. I think that’s why they’ve kind of gotten a really bad rap for individuals.

Hampton: How do annuities and target-date funds differ from the retail version?

Kephart: Yeah, so they’re a lot simpler, a lot more straightforward. They also don’t have commissions. You’re typically getting group pricing because you’re part of the 401(k) plan. You should be getting some better income than you would outside of the plan. So, there are some benefits to doing it within a 401(k).

Hampton: Now, in March, the Department of Labor issued a proposed rule providing guidance to company plan sponsors. It outlined the process for including lifetime income in 401(k)s and other defined contribution plans. Why is that important?

Kephart: Yeah, I think anytime that there’s certainty over what’s allowed and what’s not allowed, it makes plan sponsors a lot more open to trying things. Plan sponsors aren’t really incentivized to be innovative or pick the best-performing funds. They’re really incentivized to not get sued. Anything they could do to have some safety in a safe harbor will make them more, I think, interested in looking at things that are a little bit unusual, like these target dates with annuities.

Hampton: Now, Vanguard has rolled out a target-date fund series with built-in lifetime income. What do you make of the behemoth asset managers’ move, and is momentum building for guaranteed income in 401(k)s?

Kephart: Yeah, we’re starting to see momentum building, and I think Vanguard coming into the market is huge. They haven’t launched a new target-date series since 2003, so this is very big for them. A lot of other asset managers will have four or five different target-date series. Vanguard’s been sticking to its guns. The fact that they’re seeing enough demand to make them want to go in this direction, I think, definitely signals that it’s something that we’re going to be hearing a lot more about going forward.

Hampton: Now, target-date funds with annuities make up a fraction of the overall target-date-fund market. Do you think the annuity version could become more popular than its sibling in the future?

Kephart: I think it would take a very long time. I think there’s a lot of inertia in 401(k) plans. I think it’ll take a lot for them to really flip the leaderboard. But I do think we’re going to start seeing them grow, and it’s more likely that you might start seeing it in your own company 401(k) plan than not.

Hampton: Your research examined the types of annuities that are currently found in target-date funds. We have income and guaranteed lifetime withdrawal benefits. Can you explain the similarities and differences?

Kephart: Yeah. Those are the two umbrellas, but underneath there, there are a lot of small variations, and no two series really do it the exact same way, but generally, you get to the same point in one of these two ways. The income annuity is kind of what people probably think about. You hand over a lump sum of money, you never see it again, but you get paid back income steadily until you die. The guaranteed lifetime withdrawal benefit lets you hold on to your assets, and you have more liquidity. You basically have a guaranteed rate of withdrawal, so maybe 5% or 6% that the insurance company will guarantee for you. Even if you withdraw the entire portfolio, you’ll still get that 5% check. That’s when the insurance would kick in.

Hampton: Let’s zoom in on income annuities. Which firms are offering these?

Kephart: Yeah, so this is like BlackRock, Vanguard, Nuveen. These are the ones that are, I think, a little bit more straightforward. These are the ones where a certain percentage of your portfolio will be handed over to the insurance company, and that will, in turn, get you a stream of income. That’s the most straightforward way to do it, I think.

Hampton: What are the trade-offs of annuities in these types?

Kephart: Yeah, so I think the challenges are that you’re giving up the money; you no longer have control over it. In general, I’d say annuities are better the longer you live, but if you give that money up and you die the next day, there are certain things you could do to protect some of that, but in general, you should pretty much consider that money gone. That’s one of the big trade-offs and probably a hard mental hurdle for some people. Also, the fees are not transparent. They’re typically embedded in the payout rate, so you don’t really see what the fee is. That makes it a little bit harder to do apples-to-apples comparisons.

Hampton: Now, which providers offer guaranteed lifetime withdrawal benefits?

Kephart: Yes, that’s like JPMorgan, AllianceBernstein. I think what those do is that you have the flexibility, but you also have an explicit 1% fee, usually, once you opt in for the guaranteed withdrawal benefit. You could withdraw more than that, but what happens is your guarantee is going to drop. Say you have a 5% guarantee, medical bills come up, and you have to take 10% out. Maybe going forward, it’ll be like 4% instead. You still have that flexibility, which people like, but there’s also a chance that maybe if you don’t run out of money in your portfolio, you are paying the 1% fee for something you didn’t really need or ever use. I think that’s kind of one of the trade-offs there.

Hampton: So, those are the pros and cons of this type.

Kephart: Yeah.

Hampton: Target-date funds with annuities are limited to 401(k)s and other defined contribution plans. How should retirement savers figure out whether they want to divvy up this money or reallocate their workplace savings?

Kephart: Yeah, I think it’s early days, but I think it’s an issue everyone’s going to run into at some point. How am I going to turn my nest egg into something I could live off of? We’re obviously very familiar with our colleagues Christine Benz and Amy Arnott’s awesome research on retirement withdrawal strategies, but this kind of throws another wrinkle in it. I think one of the challenges with it is with these target dates with annuities, where they’re kind of assuming that all of your 401(k) money is in that target date. What we’ve seen the data show is that that’s not typically how a lot of people are investing right now. The older you are, the more likely you are to use the target date as part of your portfolio. If you’re only going to annuitize a fraction of a fraction, you may see payout rates that don’t seem worth it. It’ll be really interesting to see how that kind of trends over time.

Hampton: More to research, more to research. Morningstar plans to rate these funds. What can you tell us now?

Kephart: Yeah. We want to be able to help investors make really good decisions, evaluate these products, and give people a sense of what they are, how they work, and do we think they’re good or not? We’ve always got our pulse on what’s new and hip, and these are definitely on our radar. It’s something I think we’re taking a very close look at now.

Hampton: What’s the takeaway for investors as choices for target-date funds with annuities grow?

Kephart: Yeah, I think the takeaway is: On one hand, annuities aren’t for everyone, but they can be a really useful tool in the right circumstance. It’s one of those things that I think people are going to have to think a lot about. I think one of the things that’s table stakes for a lot of these firms bringing these to market is that they’ve really got to work on the education and make it very easy to understand. I think that’s kind of been table stakes for the firms gaining some traction, like BlackRock, and not just a simple retirement income calculator, but different ways to really understand what you’re getting and make it clear to investors so they actually can make really informed decisions.

Hampton: Jason, thank you for coming to the table and telling us what we need to know about target-date funds with annuities.

Kephart: Thanks for having me. Next time, we’ll have to talk about target dates of private markets.

Hampton: That wraps up this week’s episode. Thanks for making this show part of your day. A couple of reminders: Give Investing Insights five stars on Apple Podcasts to help others find the work we’re producing for you, and subscribe to Morningstar’s YouTube channel to see new videos from our team. Thanks to senior video producer Jake VanKersen. I’m Ivanna Hampton, editorial multimedia manager at Morningstar. Take care.