If you’ve received notice that your 401(k) plan now offers annuity options, you may want to look into what these products are, and how they can help you plan your retirement.
Imagine Geoff, who is 50 years old, and recently received an email from his 401(k) plan administrator encouraging him to purchase annuities. He currently has $650,000 in his 401(k), and he always contributes the maximum amount to take full advantage of his employer’s matching program. He thinks that he will retire at age 65. Are annuities a good option for him?
The passage of the 2019 SECURE Act made it easier for 401(k) plan administrators to offer annuities (1). This change was meant to give Americans more options for guaranteed retirement income.
An annuity is an insurance product that can help you meet long-term savings goals. When you purchase an annuity, you make a lump-sum payment, or a series of payments, and the insurer agrees to make payments to you either at a specified date, or immediately (2).
Deferred annuities will provide payouts in the future, while immediate annuities begin payouts right away (3). Tax is typically deferred on investment earnings within an annuity, and gains are taxed at ordinary income rates, not capital-gains rates, when withdrawals are made (2).
There are three types of annuities — fixed, variable and indexed. A fixed annuity will have a fixed interest rate (though it may be fixed only for a set number of years) as your investments grow, and payments at a specified amount (4).
With fixed annuities, you can choose whether payments are for a set period of time, lifetime payments or payments for the lifetime of you and your spouse. Options where beneficiaries receive payments after your death may need to be purchased as a rider. Fixed annuities are popular because they offer a dependable rate of return and income stream. Because payouts are not affected by market fluctuations, they can also offer peace of mind.
Variable annuities are a more complex product. They offer different investment options, and your rate of return depends on the performance of your investments. A plus of this product is that it typically offers death benefits for specified beneficiaries. However, one drawback, according to the Financial Industry Regulatory Authority (FINRA), is “unlike a term life policy, where the beneficiaries in most instances receive more than the premiums made, beneficiaries of variable annuities are generally only guaranteed a return of the premium, net of any withdrawals (4).”
Indexed annuities, similar to both fixed and variable annuities, “typically offer a minimum guaranteed interest rate combined with an interest rate linked to a market index (4).”
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Annuities can include various fees, the possibility for high commissions, and you may have to pay extra for features or riders if you want to ensure a death benefit for your heirs or guaranteed minimum income for yourself (3).
Fixed annuities include risks like inflation impacting the purchasing power of your payouts (unless your agreement includes an inflation rider that raises payments over time, and the costs of this inflation protection can be significant), and if your interest rate is only fixed for a set number of years, you also could face lower returns in the future (5).
FINRA notes that with variable annuities annual expenses are likely to be much higher compared to other investment products such as mutual funds (4). Variable annuities also carry more risk than a fixed annuity, as there is no guarantee of a return on your investment.
Indexed annuities, by comparison, can be confusing for average investors to understand, and are difficult to compare to one another in terms of their benefits and payouts.
Another drawback with annuities is that they come with liquidity risk. According to FINRA, if you withdraw money before you turn 59 ½, you may face a 10% tax penalty (5). And many annuities will have set holding periods, and charges if you want to withdraw your cash early.
For an investor like Geoff, an annuity may be something that he should wait to invest in. Annuity programs have high fees that can eat into a younger investor’s overall nest egg. Moreover, tapping into his savings early may incur charges and tax penalties.
As Geoff gets a bit closer to retirement, he might consider whether his portfolio needs rebalancing toward less risky investments, and whether annuities would fit into his overall retirement plan, offering him the peace of mind that comes with reliable income.
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Money.com (1); SEC (2); FINRA (3), (4), (5)
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
