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Annuities

While owning a mix of investment options is often touted as a good long-term investment strategy, many workers are concerned that market volatility can damage their nest eggs. That’s especially true for older employees who may not have enough years to recover from slumping markets and for those who will depend almost entirely on their 401(k) plans because they won’t receive a pension.

Accordingly, many employees may increasingly look for other investment options, and a small but growing number of employers are responding by adding annuities to their 401(k) plan options. The move to include annuities has been spurred largely by the disappearance of traditional pension plans. According to the 2006 National Compensation Survey benefits data, only 20% of the surveyed employees had traditional pension plans. Participation in savings plans such as 401(k)s, however, had increased to 43%.

The Mechanics

Annuities enable employees to generate a predictable income stream with their 401(k) plan balances. In a typical arrangement, employees can have part or all of their 401(k) contributions invested in the plan’s annuity account. An annuity account can be a guaranteed account, which is guaranteed subject to the claims paying ability of the company issuing the account.

An investment in the annuity account creates a guaranteed retirement benefit; the benefit amount depends on the person’s age at the time of investment and retirement. There maybe additional fees and expenses in the 401(k) for the lifetime income benefit. Here is a hypothetical example that demonstrates how the annuity may act: a 40-year-old who invests $200 a month in a fixed annuity and retires at age 65 may receive a $1,000 monthly lifetime benefit.

Annuities’ Benefit

Annuities provide the following benefit:

  • Predictable monthly income. After retirement, your focus will likely shift from growing your accounts to managing withdrawals so the funds could last a lifetime. That’s more difficult than it sounds. Many people think that they can just start taking a fixed withdrawal out of their portfolio each year. But if their portfolio’s value drops, they must sell more shares to receive the same monthly income. If they don’t reduce their withdrawal every time that happens, it will reduce the portfolio more quickly than planned.

Annuities’ Drawbacks

Their most significant drawback is a lack of portability. Ordinarily, when you change jobs, you can roll money from your former employer’s 401(k) plan into an individual retirement account, or into your new employer’s 401(k) plan. But unless your new employer offers the same annuity option as your old one, which could be unlikely, you probably won’t be allowed to roll your annuity into your new employer’s plan. You might be able to leave it in your old employer’s plan, but you wouldn’t be allowed to contribute more money to it.

Evaluating the Annuity Option

Many 401(k) plans are just starting to consider annuities. If your plan eventually expands to include that option, you may want to consider the following before signing up:

  • Flexibility. Does the plan allow transfers of funds invested in the annuity account to other investments in the plan? What will that transfer cost? Can you withdraw part of the funds before retirement?
  • Portability. If you change jobs, what happens to the funds you’ve accumulated in the annuity account? Can you transfer them to your new employer’s plan or roll them into an IRA?

Choose the annuity option if it makes sense because of the annuities features, such as lifetime income payments and death benefit.

Remember, qualified withdrawals from 401(k) plans are taxed as ordinary income and, if taken prior to age 59 ½, may be subject to an additional 10% federal tax penalty and possibly state income taxes. There may be surrender charges and termination fees associated with a qualified retirement account.

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