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Annuities: what are they and who needs them?

A while back I wrote about the possible changes coming to retirement plans thanks to the Secure Act the House passed in May. The bill is stuck in the Senate as of now. but I think it’s likely that those changes will eventually occur one way or another.

If you currently contribute to a 401k plan at work, you should be prepared to see some a new product being offered to you: a variable annuity. Those with 403b plans (generally, nonprofit and school system employees) might already be familiar. While 403b plans and 401k plans are functionally very alike - they’re the retirement plans established by an employer, with similar limits, rules, and tax advantages, and they occupy the same place is someone’s financial plan - there are some differences, owing mostly to how the two plans came about.

403b plans are much older than the more-familiar 401k, and were mostly sold by insurance companies, whose principal product was annuities. To this day, even though mutual funds and other, lower-cost products have been allowed to be offered for decades, most 403b assets are in a high-cost annuity of some kind. This is because many 403b plans are not covered by ERISA, which is the federal law that sets standards intended to provide protection for the participants of private retirement plans. This has created a kind of lawless gap in the retirement savings landscape, with many public employees being ushered through it. And now we come to the Secure Act, and how it might do the same for the 401k plans that have thus far been spared.

One provision of the Act is a safe harbor for plan sponsors who want to offer a lifetime income product (aka annuity - be on the lookout for that language) in the investment menu. This means that if a sponsor chooses an annuity company, who then goes bankrupt or engages in poor practices, the sponsor themselves can’t be sued by the participants. And so, sponsors will be free to choose whichever company - good or bad - plies them with perks and gifts, with the participants paying for it all via high fees. And incidentally, our general innumeracy and discomfort with the idea of doing math as a society isn’t helping here.

So what are annuities, anyway, and why are they such a bad product to own?

Truly, they’re not. They absolutely have a role in a retirement plan. At their simplest, annuities are a way to turn a lump sum of money into a guaranteed stream of income. When you’re close enough to retirement that you have a good sense of what your living expenses will be, how much longer you will work, and how much more you can save between now and then, it makes sense to look into the possibility of taking some uncertainty off the table. If you have saved, say, $500,000 for retirement, your simplest options are:

  1. Simply withdraw what’s needed from the $500,000 each year, after factoring in other income, such as Social Security, and hoping the money lasts long enough to meet your needs

  2. Purchase a single-payment, immediate annuity, or SPIA, with some or all of the money, after having shopped around and found the best deal (comparing things like cost of living increases, the impact of having survivor benefits, etc). This will guarantee you a stream of income for life, and you won’t be dependent on market returns or timing of withdrawals. The payments start right away after you purchase the annuity.

  3. Purchase a deferred income annuity, or DIA, with some or all of the money, again after having shopped around and compared features. This product is purchased well before payments start, and the income received is much higher. But the lump sum payment is no longer under your control, and you could miss out on market growth in the meantime.

As you can see, there’s certainly a place for the simpler kinds of annuities, for savers who don’t want all of their assets exposed to market risk. So what’s wrong with saving that way all along?

One of the big selling points of an annuity, particularly the ones more complex types than those I mention above (like variable and indexed annuities), is that the growth is tax-free. But the money you would contribute to a 401k, 403b, or IRA, and the growth of those contributions, is already tax-deferred, so that benefit is really of no value. On top of that, the fees on products like this often top 2%, which is an outrage. And worst of all, if a younger saver chooses one of these products over, for example, a broad market index, they are foregoing DECADES of growth that would otherwise do a lot of heavy lifting towards a successful retirement. But the typical pitch for these tends to play on fears of not having enough money in retirement, and the “guarantee” aspect is wildly oversold - you need a guarantee like that when you’re about to start spending down your money, not when you have decades of savings and life ahead of you.

So, if you start to see new products being offered soon that are trying to convince you to do something different with your retirement savings, remember to apply a lot of side-eye, and if something doesn’t make sense, call your financial planner for their input.


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