Should a 401(k) Be in an Annuity?

Do you have a 401(k) plan? If so, then you’re familiar with the advantages of saving for retirement with pre-tax dollars. You probably also know that within your 401(k), you have a choice of investments. Typically, you can invest your money in target-date funds, passively managed index funds, and actively managed mutual funds. Some plans allow you to purchase annuities, another option for funding retirement.

Many plan sponsors are reluctant to offer annuities within their 401(k) plans, however, so they’re not a common option. According to the Plan Sponsor Council of America, fewer than 10% of workplace retirement plans offer lifetime income solutions. 

Even though including this option might improve workers’ retirement security, annuities are a more complicated offering than the typical fund offerings. The fees can be substantially higher, depending on the type of annuity. The choice of insurance provider also entails risk (annuities are sold by insurance companies, and some insurance companies are more financially sound than others). In short, plan sponsors increase their chances of being sued when they offer annuities.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was passed into law in December 2019, gives employers greater leeway to include annuities in their workplace-sponsored retirement plans. That’s because, under the new law, there is less risk of being sued if the insurer they pick to make annuity payments goes bankrupt and can’t pay claims.

Why Would You Want an Annuity in Your 401(k)?

One of the biggest concerns for a retiree is running out of money. In a 2018 survey by Aegon, 52% of respondents expressed this fear. Annuities are an appealing solution to this problem because they can provide a lifetime of guaranteed income, depending on the kind of annuity you buy. In an era when defined-benefit pensions have largely been replaced by defined-contribution plans, such as 401(k)s, the opportunity to create a “self-funded pension” with an annuity may be reassuring to many retirees.

While 401(k) plan providers have found ways to make it easy for workers to save for retirement through automatic plan enrollment, matching contributions, and default investments, they have not made it easy for workers to turn their savings into a steady, enduring stream of retirement income. It is up to retirees to decide how to draw down their assets and how to change their asset allocation throughout retirement (though the target date funds many plans offer can simplify the latter).

Buying an immediate life annuity would give a 65-year-old male the most income among the available options, according to an October 2019 paper from the Boston College Center for Retirement Research, which receives federal government funding. The authors make a case for traditional annuities by showing a case where annuitizing is superior to investing with 3% returns, taking annual withdrawals based on remaining life expectancy, and taking required minimum distributions (RMDs). It would also prevent the retiree from running out of money.

How Much Monthly Income Could an Annuity Give You?

Let’s be clear about what not running out of money actually looks like. If this man buys a $100,000 pure life annuity, his monthly income for life is only $525, according to an estimate from ImmediateAnnuities.com. That payment will never be adjusted for inflation, and the “pure life” part means his heirs won’t receive anything when he dies, even if he dies long before he breaks even.

He can make sure his annuity pays out for at least 10 years, even if he dies during that period, by reducing his monthly payment to $512. These 10 years are called a “period certain.” This way, his heirs get something if he dies prematurely. Another option is to make sure his heirs receive a refund of his unused premium by reducing his monthly payment to $478.

Many retirees have spouses to consider. This man could also buy a joint 100% to survivor annuity with his $100,000. It would pay $442 per month for life as long as either he or his wife (also age 65) were alive, and it would also have the 10-year period certain guarantee.

Source: ImmediateAnnuities.com.

By comparison, here are the payouts you might expect from having similar balances in an index fund (keeping in mind that market fluctuations and the sequence of returns could change things significantly).

Source: Financial Mentor.com. “Retirement Withdrawal Calculator.” Assumes average annual growth of 6% and an inflation rate of 3%.

Advantages and Disadvantages of Buying an Annuity Within Your 401(k)

All of this means that there are a number of factors on both sides to consider when thinking about whether it makes sense to hold an annuity in your 401(k).

Advantages of Buying an Annuity in Your 401(k)

David Blanchett, head of research for Morningstar Investments, writes about some advantages of buying an annuity within a 401(k) in an April 2019 piece for the Wall Street Journal.

One advantage of buying an annuity within your 401(k)—if you’re female—is that your gender won’t affect the price. Annuity prices reflect life expectancy, and outside of a 401(k), women can expect to pay more because they live longer on average. On the other hand, bought within a 401(k), this smoothed-out pricing means men might pay more.

Annuity payments might also be higher within a 401(k), Blanchett writes, because insurers can save money on marketing when they have a large pool of potential customers supplied by an employer. But you shouldn’t assume payments are better without seeing what outside annuities have to offer, he cautions.

Plan sponsors have certain obligations to plan participants under the Employee Retirement Income Security Act (ERISA). So it would be natural to assume that if your plan sponsor offers an annuity within your 401(k), it’s been vetted as a solid choice that will deliver on its promises and not rip you off with unreasonable fees. However, it’s unwise to blindly trust that your employer has made an ideal choice.

Why is that? As we’ve seen, employees have brought lawsuits against 401(k) plan sponsors for excessive fees. In addition, the funds in many retirement plans are known for charging higher fees than workers would pay in similar funds offered outside the plan.

Further, the SECURE Act does not contain a requirement that employers provide low-cost annuities. If the annuities offered within your 401(k) are not satisfactory, rolling over part of your 401(k) to an outside annuity is another option (one that is too complex to delve

into here).

Disadvantages of Buying an Annuity in Your 401(k)

If you were to buy a deferred annuity, in which you wouldn’t start receiving an income stream until perhaps a decade or more after buying the annuity, your annuity principal would grow over that decade. You could expect to receive an interest rate similar to what a certificate of deposit would pay, which would be similar to the inflation rate. Therefore, your money will grow more slowly than it might if invested in the stocks or ETFs.

Annuities have the same tax-deferral benefit as 401(k)s do. You don’t pay taxes on the growth in an annuity—or on the money in a 401(k)—until you take the money out. So one argument is that it doesn’t make sense to buy an annuity in an account where you already get the benefit of deferred taxes. In a separate article, Blanchett suggests purchasing an annuity using the money in a taxable account if you have the funds.

Many people don’t have the funds in a taxable account to buy an annuity, however. People tend to hold most of their net worth in their retirement accounts and in their home equity. And you need cash on hand in case of an emergency, because getting money out of an annuity can entail surrender charges if you’re in the first seven to 10 years of a deferred annuity and you’re still in the accumulation phase. Also, once you’ve annuitized, or started receiving payments, your decision is usually irrevocable.

For these reasons, it becomes logical to tap a 401(k) to buy an annuity. It’s also logical to use the money you’ve specifically set aside for retirement, rather than some other pot of savings, to provide a retirement income stream.

A concern people have about buying annuities is dying before they’ve at least broken even with the principal they’ve put into the product. With any type of insurance product, the way insurance companies stay in business is through some customers coming out ahead, some coming out behind, and others roughly breaking even. Money that you use to buy an annuity is money that you generally cannot leave to your spouse, children, or other heirs. But it can be if you’re willing to pay more to obtain principal protection or period certain benefits, as explained in the earlier example.

Types of Annuities Allowed in 401(k) Plans

A qualified longevity annuity contract (QLAC) is a type of advanced life deferred annuity funded with an investment from a qualified retirement plan, such as a 401(k) or an IRA. In 2020, an individual can use 25% or $135,000 (whichever is less) of their retirement savings account to buy a QLAC.

The main benefit of QLAC is a deferral of taxes that accompany RMDs. The QLAC’s value is not included in RMD calculations. It must begin paying out by age 85. A retiree or near-retiree might wish to buy a QLAC at age 70 before RMDs kick in at age 72 if they have plenty of retirement income from other sources. RMDs used to kick in at 70½ before the passage of the SECURE Act, but the new age is 72.

Only half of the plan sponsors surveyed by the Callan Institute, which provides continuing education to institutional investment professionals, said they offered a “retirement income solution” in 2018. Only 1.4% said they offered QLACs. So despite the IRS making this option available in 2014, it hasn’t caught on.

The QLAC is not the only type of annuity you may be able to purchase in your 401(k) plan. You may be able to buy other types, such as a simple fixed immediate annuity (shown in the first table earlier in this article), the far more complicated and expensive variable annuity, and the slightly less complicated and expensive indexed annuity.

The Bottom Line

Few 401(k) plans offer annuities today, and even when they do, workers usually don’t choose them. But there’s a push to expand this option, as the SECURE Act demonstrates. Further, as the Center for Retirement Research paper points out, with so many workers now dependent on 401(k) plans, “the question of how they will manage their accumulated assets over their retirement takes on increased urgency.”

Whether to buy an annuity within a 401(k) is a complicated decision that can have a big impact on your retirement. It’s highly personal, and what your coworker is doing or what your HR rep thinks sounds good may not be the right choice for you. It’s important to have all the facts and compare your options so you can get the decision right.

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