If retirement legislation now under consideration in Congress becomes law, your 401(k) plan might have a new look.
The Secure Act, which passed the House in May and awaits Senate action, includes a provision that would make it easier for companies to include annuities in their retirement plans. And while people may be drawn to these guaranteed-income options, it’s important to grasp both the pros and cons before putting any money into one.
“As with any investment, It’s important to understand how it works, what it costs and how it fits into your overall financial plan,” said Frank O’Connor, vice president of research for the Insured Retirement Institute.
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The Secure Act — whose main goal is to expand access to retirement savings — has idled in the Senate despite bipartisan support. A handful of Republican senators sent a letter to Senate Leader Mitch McConnell, R-Ky., this week, urging consideration of the wide-ranging bill as soon as possible. However, it remains uncertain when that might happen.
For people interested in ensuring they receive lifetime income from their savings, the provision relating to annuities may be of particular interest.
While companies already can offer annuities in their 401(k) lineups, just 9% do, according to the Plan Sponsor Council of America. The Secure Act aims to eliminate companies’ fear of legal liability if the annuity provider collapses or otherwise fails to deliver.
Although an annuity might include an investment component, it’s essentially a contract: You hand over your money — either all at once or through regular contributions — and the provider (typically an insurance company) promises to provide regular payments to you across many years. Sometimes, that can be decades.
A man reaching age 65 can expect to live, on average, until age 84, according to the Social Security Administration. For a woman, the average is 86.5. About a third of all 65-year-olds today will live past age 90, with about 1 in 7 living beyond age 95.
For people who worry about outliving their assets, an annuity can help ensure that their savings will last their lifetime. Yet they can be tricky to understand and often are more expensive than other choices for where to keep your money.
“An annuity serves as guardrails for your principal at the same time it provides guaranteed life income,” O’Connor said. “But, it comes with a cost. There are fees that options without an income guarantee don’t have.”
Nevertheless, annuities can make sense for some people.
“If someone decides to get an annuity, they’re doing it because they either need guaranteed income for life or they need peace of mind,” said certified financial planner Malik Lee, managing principal of Felton & Peel Wealth Management in Atlanta. “But you should want a fiduciary on your side to help you navigate them.”
Although annuities can vary widely — both in terms of cost and particular guarantees — there are some broad commonalities.
For instance, once you hand your money over to the insurer offering the annuity, it can be costly to change your mind after a short initial review period.
Depending on the contract, you could pay what’s called a surrender charge after that window if you no longer want the annuity or withdraw more from it than allowed. That fee can be pretty steep, especially in the early years of the contract.
By way of example: An eight-year surrender period might come with an 8% charge in the first year that gradually decreases before reaching 1% in year eight.
Also, it’s important to know that if you take money out of an annuity before age 59½, you’ll pay a 10% tax penalty, just as you would for any early withdrawals from 401(k) plans and traditional individual retirement accounts.
Otherwise, the annuity payments made to you are taxed as regular income, assuming you haven’t yet paid any taxes on the money you used to purchase the contract. (If you use after-tax money, only the interest or earnings portion of your payment is taxed.)
Annuities can be immediate, which involves starting the income stream right away. Others are deferred, in which case at some future date you can annuitize — meaning you agree to receive a periodic amount — for a set time period or for the rest of your life.
Both immediate and deferred annuities can be fixed or variable. A fixed annuity gives you a guaranteed rate of return on your principal.
“If interest rates go down, these contracts have a minimum guaranteed minimum interest rate,” said Bryan Bibbo, an advisor with the JL Smith Group in Avon, Ohio. “But if rates go up, yours won’t.”
Variable annuities are the other main type. These tend to be the priciest of the annuity options, with the average annual cost around 3% of your account. That amount includes the price of riders that consumers often buy — such as a death benefit for heirs if you pass away before depleting your annuity or coverage for long-term care.
By comparison, actively managed mutual fund fees average below 1% yearly. Index mutual funds and exchange traded funds generally have even lower fees. Remember that the yearly amount you pay for any investment reduces your return.
When you buy a variable annuity, you choose from a menu of underlying funds, which generally are invested in stocks or bonds, or a mix of the two. This means the value of your investment will fluctuate with the performance of those funds.
Meanwhile, indexed annuities are a hybrid of sorts. While the earnings are based on a stock index — say, the S&P 500 — you only get a share of that index’s performance. That could be anywhere from 10% to 60% of the index’s return, Bibbo said.
Additionally, indexed annuities typically come with caps on their return. In other words, if the cap is 3%, that’s what you’ll earn even if the index rose 10%. There also are other fees that can eat into returns, depending on how the annuity is structured.
“The biggest plus is protection of your principal,” Bibbo said.
Interest in annuities among 401(k) participants appears to run high: About 75% say they are interested — either very or somewhat — in putting some or all of their workplace savings in a guaranteed-income option, according to a recent report from the Employee Benefit Research Institute.
Whether the Secure Act will boost the number of 401(k) plans with annuities remains to be seen, as well as whether there will be limits on the types of annuities offered. Lee said that without an insurance agent serving as the middle man who gets a commission, the cost of annuities inside a 401(k) might be lower than outside of it.
Nevertheless, experts stress that annuities should not be considered in a vacuum, but rather as a possible piece of the retirement-income puzzle. And, professional advice that’s impartial can go a long way toward making sure you don’t end up regretting your decision.
“You should be taking a holistic approach to your retirement plan,” Bibbo said. “An annuity can make sense within a financial plan, but outside of that it’s just a product.”