With the SEC making the offering of annuities in companies’ 401(k) retirement plans easier, we are now scrambling to make this type of investment more transparent.
There is something particularly tempting about annuities that appeal to a lot of people, for the same reasons that they loved fixed benefit pension plans. There is no doubt that the comfort of knowing you will receive a certain amount of income for life does sound pretty good to a lot of people, especially given the considerable amount of uncertainty that most face in retirement.
Choosing where to put your 401(k) money is a big decision, and goes beyond just having a good understanding of the fees and benefits of annuities, as we also have to be able to make an intelligent comparison with other investment options such as stocks and bonds. We need to start by looking at annuities themselves though and have that part transparent enough before we can move on to see how they may stack up.
When we do measure them alongside alternatives, this won’t be just a matter of coming up with an idea of which is better overall, as our own particular situation will weigh on this decision as well. Both the investment industry and investors love cookie cutter approaches, such as having half of your assets in stocks and half in bonds in retirement, or other simple-minded calculations, but people’s situations do differ, and to the extent that a plan does not conform to our needs, we have acted unwisely.
We approach this overall in a way that would have everyone coming in to a clothing store that only has one size, one size that is supposed to fit all but just doesn’t. Even worse, the design of the clothing turns out to not be very high quality either, something that you may be able to get by on but one that could be bettered by shopping around more and not just wear what the big store in town wants to sell you.
Whatever broad recommendations that we arrive at will have to ultimately consider the benefits of annuities generally, as well as whether these general benefits are the right size for a given investor, which means that we’ll have to take some measurements of both the annuities and the potential wearer.
The squeaky wheel right now is at the level of product transparency, which is the main focus right now of the SEC as well as private groups such as the Alliance for Lifetime Income, a Washington-based nonprofit group that serves to educate people about investing in annuities.
When you have an organization that advocates for a certain type of investment and just advises on that, while this may indeed help people navigate the fairly complicated landscape of annuity investing, this is bent toward annuities, and we will also need to place what we learn here in more perspective, to decide whether we want to choose to include these investments or not.
Annuities are an insurance product that pays out its benefits not just upon your death but while you are alive as well. When you purchase an annuity, you are trading your lump-sum contribution for a future stream of income, not unlike a bond does, but this type of investment doesn’t have a maturity date and just keeps paying out the income until you die, at least with life annuities, which are designed to do just that.
If we do decide to invest in such a product, we obviously need to compare annuities to select the best one, although that’s not now it is done typically. People are typically just sold annuities and they just basically just walk into an annuities store and get handed one right over the counter, without any comparison shopping or even thinking about the matter beyond just liking the idea of this overall.
With the new provisions of the new Secure Act allowing for annuities to be included in 401(k) plans, we need to realize that we really won’t have this opportunity to shop around, because this arrangement is exactly like our big store. You ask for an annuity, the company chooses one for you, and hands it over.
This is a situation where you have to take whatever is offered, and although this does not mean that fees do not matter, it is the net return that we need to focus on. This is the bottom line, how much we get paid from it and how this compares to how much we have invested.
While there are some annuities that have such high fees that some consider them to be predatory, companies can get away with this more by direct selling, where agents use their selling skills to hook us up and pad their profits. When you’re dealing with a large 401(k) plan, this at least puts prospective annuities buyers in a better position theoretically, where the buying power of many will command better deals.
This is where the focus needs to be right now from a regulatory perspective, to help ensure that the interests of participants in these plans are held captive to a more desirable arrangement, one commensurate with the buying power of the plan.
We Pretend that Caveat Emptor Does Not Apply to Investments, But We’re Dead Wrong
There is plenty to do here on the retail side of things as well, when investors place a great deal of trust in the people looking to sell them such things, and where this trust ended up not warranted.
People are generally responsible for their own shopping. When we go to a car dealer, we don’t expect them to play a fiduciary role, and expect them to do their best to talk us into buying their car. We could argue that the same buyer beware principle should apply to buying investments as well, and it for the most part does, with very few restrictions, but people fool themselves a lot about this and that’s the real problem.
The work to tighten up this relationship is focused not only on annuities but on the investment business as a whole, where we want to see advisors put their clients’ interest first. This is not an easy task given that these advisors are often compensated based upon the amount of business they generate, where one product may be more lucrative for them financially and less so for the client.
They often will choose their own self-interest, and we see this problem with the sale of annuities as well. It is always important to try to make investments more transparent, but what is even more important is the need to educate investors so that they can fend for themselves far better than any regulations can, given that they are so vague and can be easily manipulated.
It wouldn’t take much for this, as if we just asked what the costs and benefits of each annuity was, and compared with other providers as well, we would have all this information at hand and then would be in a position to decide. You can’t force people to shop around, and just asking sales people to try to avoid the worst of this isn’t going to be enough regardless.
The work of the Alliance for Lifetime Income does some good work here, and we need all the help we can get, but we need to focus even more on the investor side of things and seek to provide them with enough education so that they can protect themselves.
We have had several instances of companies being charged for the worst of their practices, and we need these regulations in place to look to prevent at least this, but the smaller stuff flies well under the radar and can only be effectively dealt with by investors themselves being diligent.
When it comes to wanting annuities in our 401(k), this becomes not about comparing annuities but with comparing them to other investment options. There is so much at stake here, so we should never be complacent about these decisions, and this usually comes down to making impulsive decisions rather than comprehensive and deliberate ones.
Where are people to turn to when it comes to deciding this though? There’s not a lot of information out there that is not clearly biased, as if you’re trying to decide whether to include an annuity in our 401(k), you shouldn’t be asking someone who wants to sell you one.
There are two main uses for annuities in a retirement portfolio, which are to provide income and to use as a hedge. Annuities are a real income investment, unlike bonds which are a combination of income and capital exposure. Annuities deliver a similar average return that bonds do, without the investment risk.
Annuities are not liquid though like stocks and bonds are, so we need to be very careful when investing in them, because mistakes cannot be undone. Although annuities sidestep investment risk, we do need to be very aware of both the opportunity cost involved as well as how suitable they may be for our particular situation.
The variable here that we will be using to decide this is comparative returns. We generally will compare both risk and return between investments, but fixed annuities at least do not involve any risk aside from the insurance company simply going under, and all we’re left to do is to just compare returns.
There still is going to be some variability here, as the returns with competing investments can vary a lot, but we can look toward their average returns to get a sense of this.
Annuities Do Have Their Place, But They Need to Fit Our Place
The goal of this game isn’t to just shoot for the best returns though, and the whole idea behind annuities is risk management in fact, so that needs to be accounted for as well. This is what makes these decisions more complicated, but there are some general principles here that need to be accounted for.
Risk tolerance should never be primarily subjective, as there are more fundamental factors in play, things that require you to take on more risk. The less risk that you need to take on, the more you can allow your personal risk preferences to be accounted, but not liking something you need should not be seen as persuasive.
We know that, while bonds don’t really outperform annuities over time, stocks sure do, and unless we can expect that the lower return that annuities provide will be sufficient to achieve our retirement objectives, we should not be considering them.
Choosing to partially fail by dedicating assets to strategies that will not give us what we need won’t serve us well either. If we need to step on the gas to get to where we are going, and placing the other foot on the brake even a little will provide a lesser expectation for us.
The great majority of investors should therefore not be even considering annuities in their 401(k)s or otherwise, because they need to press the gas pedal to the floor to get to where they are need to be.
Those of more means, who can reasonably achieve their retirement goals or better regardless, may want to consider the luxury of locking some or all of that comfort in, and reducing the risk at this point is at least sensible. You’re never completely set with investments that vary in value, and a big bear market could tear apart our expected comfort.
Annuities as a hedge can also take us away from our goals for the same reason, but also can be used in the right circumstances. All of this goes back to the suitability of annuities relative to our needs, and when our needs exceed what it can provide, we need to stay away lest we mess ourselves up further.
Hedging with annuities differs from using other asset types due to the annuity hedge being permanent. Our needs to hedge vary a lot, depending on the circumstances of the market and our own, and we require flexibility to manage this, flexibility that is not provided at all with annuities.
When we go with annuities in a comfortable situation, we are not really hedging the market as much as we are hedging our future. This is not your typical 401(k) investor though, as so few are even on a course to success, and simply need to manage their returns and risk more actively.
The vast majority of contributions that people will make to annuities in their 401(k) will be inappropriate from not only an opportunity cost perspective but from a suitability one as well. This mismatch is well under the radar of investment advice that people tend to get, so this falls into our own laps and we are the last line of defense against inferior advice.
401(k) plans can be a powerful tool to accelerate our retirement savings, due to employer matching, and with so much on the line, it is incumbent upon us to do our best to account for all of the factors involved and devise a strategy that best promotes our success. The buck stops with us, as it’s our buck, and we need to make sure that we invest it properly.