Whenever markets are volatile and especially when they drop, many discussions begin about what if anything can be done to generate guaranteed payouts in retirement plans. Some insurance companies want to influence putting annuities in every 401(k) plan as an answer.
We believe this is not a good idea. The costs and surrender fees are typically cost prohibitive and can make savers worse off. Just read through the SEC’s site on annuities, and the caution call outs will make clear other factors to be wary of too.
What is a Variable Annuity?
A variable annuity is a mixed security and insurance product. The value fluctuates depending on the value of the underlying investments which are typically a basket of equities, very similar to mutual funds or Exchange-Trade Funds (ETFs). During the savings period, investments grow tax-free just like in your 401(k). At retirement, the person can “annuitize” the value and receive a stream of payments for a guaranteed period, such as 20 or 30 years, until death. When funds are withdrawn, the investment gains are taxed as ordinary income. Some people like the ideas of fixed payments guaranteed. Unfortunately, when you know the facts, you will likely have accumulated less because of the costs; and therefore, have less to live on in retirement. And variable annuity payouts are not truly guaranteed. Even the added death benefit annuities can offer is rarely justified. Complex and costly are typical attributes of these insurance products.
The Three Reasons to Keep Annuities Out of Your 401(k)
Most variable annuities are expensive!! Variable annuities average expense is 2.3% and can be more than 3% depending on your provider.^ We advocate paying no more than 1% all-in for investment expenses – the more you spend in expenses the less that stays invested in the markets. The annuity costs (and any fund with expenses over 1%) can really add up and result in you and your employees having tens if not hundreds of thousand dollars less come retirement! High investment expenses are very tough to justify in a 401(k) plan and is beyond most any prudent person’s judgment.
Variable annuities typically have surrender charges. The surrender charges are often expensive too and are bad risk for employers to take on within their 401(k) program. For insurance companies to recover the costs of selling annuities and retain customers, they carry surrender charges that will decline over time. A surrender charge is a fee assessed on assets if you move money out of annuities or switch providers. The surrender charges are often five to seven percent of assets in year one and decline one percent a year until they go away over the next five to seven years. During this period, surrender charges are a big cost to change directions. As an employer, you are always supposed to act in the best interest of your employees and ensure fees are reasonable. If you decide you want to switch providers due to lower fees, investment performance, or other reasons, you are probably stuck if you have annuities in your plan until the surrender charges are low or expire. This puts you at risk during this period of not being able to act in your employees’ best interest.
The death benefits are of little benefit -- rarely used and can carry a big price tag too. The insurance provider may tout this attribute as a nice safety net for employees’ families. The way the death benefits works, is an employee must both die and have less money in their account than they have contributed to it. Neither is very likely. And in case that it does occur, it is expensive. Let’s assume a person has contributed $100,000 to their 401(k) annuity and died before retirement with a balance of $90,000. The heirs would receive the account balance plus $10,000 in insurance. To get this $10,000 in insurance monies, the participant would have paid 1.25% mortality and expense risk fee on the entire $100,000, or $1,250 every year. Over a 5-year period, the death benefit coverage on balances of $100,000 would cost $6,250 to receive $3,750 more. Over a 10-year period, it could exceed the benefit depending on balances.
Annuities could make sense for a part of your portfolio, but not in your 401(k). We believe annuities create real problems in managing a 401(k) plan in your employees’ best interest and these issues far outweigh the need for providing variable annuities in your company’s retirement plan.
^ Source: Annuity Fees and Commissions, Annuity.org