The unpredictable economy of the last five years has sparked many discussions about what, if anything, can be done to ensure guaranteed payouts in retirement plans. Some of the big insurance companies have suggested that putting annuities in 401(k) plans could be the answer and Uncle Sam may be listening too. If so, it’s the wrong answer.
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, packaged as baskets of equities; a model very similar to mutual funds. During the savings period, investments grow tax-free just like in a 401(k). At retirement, the holder 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 When funds are withdrawn, the investment gains are taxed as ordinary income.
Three Good Reasons to Keep Annuities Out of Your 401(k)
- Most variable annuities are expensive. Variable annuities typically charge 1.25 percent to 1.60 percent mortality and expense fees on top of the fund expense ratios. So instead of paying around 1% for all-in participant fees (what most agree is a good goal), the participant pays at least 2.25 to 2.6 percent for annuity products and often even more. Insurance providers’ 401(k) plans tend to be comprised of their own proprietary funds that often carry higher expense ratios versus those from mutual fund and ETF providers. These costs can really add up and, over the course of a career, can siphon tens if not hundreds of thousands of dollars from a retirement plan. A quick read through the SEC’s site on annuities (note the caution box), and it’s clear to see why they’re not a good fit in 401(k)s.
- The surrender charges are far too high and are a bad risk for employers to take on. For insurance companies to recover the costs of selling annuities, they carry hefty surrender charges that will decline over time. A surrender charge is a fee assessed on assets should a person move money out of annuities or the company switches 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, paying surrender charges take a big bite out of the 401(k) plan. Business owners are responsible for acting in the best interest of their employees (e.g. switching plans if there are providers with lower fees, better performance, better services, etc.). Having the ability to move swiftly can be costly if a current plan has annuities considering the massive surrender charges.
- The death benefits are small, rarely used and carry a big price tag. Insurance providers often tout death benefits as an added benefit. What they gloss over is the fact that, to qualify, the 401(k)’s owner must die and have less money in his account than has been previously contributed to it. Neither is very likely.
And in a case that it does occur, it’s expensive. For example, let’s assume a person has contributed $100,000 to his 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 percent mortality and expense risk fee on the entire $100,000, or $1,250 every year. Over a five 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 can make sense for a part of your portfolio especially as you reach retirement and you are looking for some stability to your income stream, but not in your 401(k). The costs and issues in managing a 401(k) plan in your employees’ best interest far outweigh the need for providing annuities in any company’s retirement plan.
