advantages and disadvantages of annuities in 401(k) plans

8/11/2019 Advantages and Disadvantages of Annuities in 401(k) Plans

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Advantages and Disadvantages of Annuities in 401(k) Plans

By Christine Benz and Daniel V. Farkas | 01-29-2014 11:00 AM

Christine Benz:Hi, I'm Christine Benz for Morningstar.com.

It's 401(k) Week on Morningstar.com. Joining me to discuss the role of annuities in

401(k) plans is Daniel Farkas, a senior investment consultant with Morningstar

Investment Management.

Daniel, thank you so much for being here.

Daniel Farkas: Thank you, Christine.

Benz:Daniel,I know that sometimes investors have annuities in their 401(k)

plans--they're often not even aware that they're there. Let's talk about the key

ways that annuities can be woven into 401(k) plans. There are a couple of different

ways that annuities might present themselves. Can you talk about that?

Farkas: There are two primary ways that an employee might find annuities in

their 401(k). One is as a stand-alone investment option, alongside plain-vanillamutual funds. This would be an investment product that confers real insurance

benefits to the participant in the form of market protection, guaranteed lifetime

withdrawals, and the ability to annuitize in retirement.

There is a second one, which is kind of this group annuity wrapper that an entire

401(k) can be so-called "wrapped" in. These are very different; they're totally

different animals. They confer basically no insurance benefit to participants, and

something to look out for is that they often have higher fees. Fortunately, they're

becoming less of an issue in the 401(k) space, but totally different characteristics,

despite the similar names.

Benz:If someone is looking at their 401(k) menu, trying to evaluate the choices,

how do they even know that there is an annuity in the mix? Should it be clearly

labeled that it's an annuity? I sometimes talk to people who have annuities and

really aren't sure what they have.

Farkas:I like that question, because the answer to that should be really simple,

and I don't think it is as simple as it should be.

One thing you can do right off the bat is certainly look at the names of the funds

and look for things like "guaranteed income," "lifetime income," things that

connote the types of properties that these products give people. But that's

certainly not the end of the story, because there are other funds in your lineup

that will have the word "income" or "lifetime" in them.

You can look at the investment category under which they're listed. When you log

into your account, funds will be listed under categories, such as large growth, large

blend, while an annuity product typically would be in its own category, and the

name of that category could be whatever the record-keeper calls it, but hopefully it

will be something that demonstrates to you what is under the hood.

Then, you can certainly click on funds. There should be a one-page description of

the fund. You can look at the prospectus, in which you should be able to tell, and

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high costs, and also complexity. But let's discuss the whole array of what you

perceive as potential disadvantages with this product type in 401(k) plans?

Farkas:Any insurance product is going to have a negative expected value.

Benz:What do you mean by that?

Farkas:I mean that on average you are going to have been better off if you didn't

buy the insurance; that's the case for these products. That is the case for health

insurance, life insurance, any insurance that's priced properly by the insurance

company. They are a for-profit entity. You are, on average, going to be better off

notpurchasing it.

Benz:But there will be winners and losers, right?

Farkas:There will be. And you don't purchase it for the average. You purchase it

to avoid the really bad situations. And it's the same thing with hazard insurance on

your house. You're OK if your house never burns down and you never reap any

benefit from that insurance, because you were protected against the really bad

thing happening, and that's the same thing here.

So, they are expensive, but you are getting real benefits for them. And I think you

need to evaluate as a potential buyer of these, whether you are someone that is in

the target market to reap the benefits that I just discussed. So are you someone

who really needs market protection, which is, are you close to retirement?

If you are 30 years from retirement, I think it's hard to make a case that you

really need that market protection. You might be paying for something that you

don't need.

Benz:Is there any advantage to purchasing such a product early in one's investing

career versus waiting until later, when that market protection might have a

greater sense of importance for you?

Farkas:I would say to get the market protection and to pay the insurance fee for

decades before retirement probably just does not make sense. Now it's worth

mentioning that some of these products are set up with a third stage that I didn't

even talk about. It's actually before the accumulation stage, and it's kind of a

placeholder. So, you can invest in a target-date series that is not an insurance

product per se, but it's set up to collide into the accumulation phase at a certain

age.

And so that could be something that would make sense to invest in at a younger

age. If you just want to know that you are set up to be in an annuity at a laterage, you're not paying the insurance until you actually move into the accumulation

stage. But that's really the only circumstance in which I could see doing it at a

young age.

Benz:Do you think things will move more in that that direction, where someone

will have that option within their plan versus the way things are set up now?

Farkas:They already are.

Benz:I know there are other considerations, other potential knocks on annuities


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within IRAs or 401(k)s. One thing I often think is that maybe you're doubling up

on tax advantages--that annuities themselves have some tax advantages, as does

your 401(k). Is that an issue, in your mind?

Farkas:It is. It's something to consider. Annuities are tax-advantaged. The gains

in the portfolio are tax-deferred. Every asset in your 401(k) is already

tax-deferred, so you're not getting any extra tax benefit from owning it in your

401(k). If you have sufficient assets outside of your 401(k), and if you're able to

strike a similar deal in terms outside of your 401(k), there could be a benefit tobuying something like this with non-retirement assets and expanding the scope of

assets that have this tax benefit [in your 401(k)].

I would say that a lot of times, 401(k)s are able to get institutional pricing, and

you might not necessarily find that you are able to get the same deal on your own.

Benz:It's obviously a very complex area. Do you have any tips on how to conduct

due diligence? Any places that investors should go if they want to research the

annuity options in their 401(k) plans? Any thoughts on how to do your homework?

Farkas:People don't like looking through prospectuses, but I really think,

especially with something that people are less familiar with and that are new, it

would be a good idea to read all that you can about these investment options from

what the company provides and what you can see in the prospectus.

I think some things to look for would be, obviously, costs. If you're comparing two

annuities with each other, look at the costs, and try to do apples-to-apples to try to

look at two different programs that are offering similar types of benefits. Costs

include the underlying fees, administrative fees, everything together--all the

costs--comparing one to another.

Certainly look at payout rates. Those differ across the different firms. Different

firms offer different payout rates.

Benz:And will that be clearly expressed, or will I need to wade through some sort

of complex calculation?

Farkas:That should be pretty clearly stated. There would be different age ranges

with different payout rates, and that can differ whether you are doing it as a single

person or if you want a joint rider, so that your spouse could continue getting

these benefits as you die. Of course the payout rates will be lower if you select that

option.

Then another thing I would look at would be the financial strength of the insurance

company. These are not guaranteed by the government. They are guaranteed by

one or more insurance companies, and these are very long-term contracts,

hopefully. You can get information pretty easily from rating agencies on the

financial strength of insurance companies, and the higher the better.

Benz:Daniel, thank you so much for being here. Obviously a very complicated

area, but we are glad that you could provide some clarity.

Farkas:My pleasure. Thank you for having me.

Benz:Thanks for watching. I'm Christine Benz for Morningstar.com.


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