401(k) Annuity – Rules, Pros and Cons

March 23, 2012 · 5 comments

Recently, some new rules out of the US Treasury appear to be opening the 401(k) annuity floodgates, which would probably draw quite a bit of interest from workers gun-shy from the recent market volatility and depreciation of home values across the country.  Earlier this year, the Treasury issued new regulations with a goal of dropping the fees associated with transferring assets held in 401(k) accounts into annuity instruments.  The US Labor Department is issuing its own set of guidance and rules as well, with the thinking being that more information and guidelines would keep workers more informed without falling prey to high fees.

The new rules allow for more options than previously existed.  For instance, now you can split up your 401(k) holdings and allocate just a portion to the annuity option, as opposed to the old rules requiring a full transfer.  There’s also what’s referred to as a “longevity option” which allows one to pull money out and set it aside for 20 years to kick in at age 85.  More background info can be found here.

 

Benefits of 401(k) Annuity Strategy

  • Diversification – If you already have other assets in stocks, bonds, real estate, commodities and other holdings, this would be an entirely new and non-correlated asset class.
  • Lack of Volatility – With an annuity, you know what you’re getting.  No market volatility, no crashes, but of course, no upside.
  • Pension Supplement – If the thought of fixed income is attractive in retirement, but your pension and Social Security mix will not be enough to sustain your standard of living, using an annuity could further increase your monthly income.

Risks of a 401(k) Annuity Strategy

  • High Fees – A common knock on annuities of all types is that the fees are high.  Frankly, people get rich selling annuities because they collect a huge upfront premium.  Hopefully the costs will come down if the volumes go up and consumers are more educated.  Another critique is that sophisticated investors can build their own annuities with complex instruments and no fees, rather than paying for the same thing up front.
  • Inflation Risk – If the country does eventually experience a bout of high inflation or worse, hyperinflation, the annuity option is going be a killer.  The fixed monthly income will be worth less and less over time in terms of real dollars.
  • Opportunity Cost – Per the prior item, in a period of high inflation, while it’s not guaranteed, investors have at least a decent shot of strong returns in equities, real estate and commodities which tend to increase in value as inflation increases.  If there are more dollars in the system under our current fiat currency model, that’s more money consumers are spending, higher profits, more dividend increases which all benefit stock investors.  Likewise, as hard assets become more expensive in an inflationary environment, landlords can increase rents quickly and real estate appreciates.  In an annuity, you’re stuck with a fixed monthly income regardless of any market upside.
  • Loss of Flexibility – If you had your money in a cash/bond mix with a similarly low yield, at least you could pull it out or change your strategy if necessary.  With an annuity, that’s not an option.

 

Would You Consider a 401(k) Annuity Conversion?

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roger wohlner April 10, 2012 at 3:42 pm

Good article you’ve enumerated some of the pros and cons quite well. A few others:

Who will determine which annuity providers are appropriate? Many retirement plan sponsor have a difficult time monitoring and selecting the appropriate funds to offer. Selecting an annuity provider who provides and appropriate product with reasonable fees will only add to this burden for many sponsors.

Many employees shift jobs several times during their careers. If they pay the fees for this benefit will they lose these fees if they move to another employer? Is this protection portable?

I fear that having an annuity available will cause many participants to lose sight of the fact that their ultimate retirement security is still based on the amount they save and how they invest those savings. Even with an annuity in place the benefit will be based upon the amount in their 401(k) account.

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