Less than 10% of employee-sponsored retirement plans offer an annuity option, although this may change with new federal legislation about to be passed.
There is much debate about whether it is a good idea to put some or all of your retirement savings into an annuity, and there are arguments for this on both sides. The very idea of placing tax-deferred money into an annuity is something that many advisors find themselves at odds with, and not without good reason.
One of the biggest benefits of investing your traditional 401(k) or IRA savings is that the returns gained continue to grow tax-free and therefore compound at a higher rate than you would see with investing your money in a similar unsheltered investment such as a mutual fund. Since a lot of the power enjoyed by investing long-term is in compounding, more compounding is even better and can make a real difference in how much you end up with when you retire.
Putting your money into an annuity instead misses out on this, since annuities don’t really compound, or rather, the money does but the insurance company that provides the annuity benefits. This is not tax-deferred so it’s not a matter of their being able to pass on tax benefits to us because there are none to pass on.
Annuities also differ widely by way of the fees they charge, and while we’re always going to pay management fees, the market for the management of our retirement plans is a much more transparent and competitive one, and we also have our employer doing our bidding for us and getting us a better deal on this, or at least this is how it should work.
A lot of the discrepancy may arise out of how annuities are sold, and all insurance products suffer from wider fluctuations than with other services. A salesman visits you, he or she presents what looks like a nice idea, you sign your name and then you shake hands. We don’t shop around for insurance products anywhere near as much as we should, and this is particularly true with annuities.
Perhaps if this was a more popular option among savers and more employers became more involved in promoting them, annuities could be made more competitive at least in terms of fees, but we’re not going to resolve the tax deferral situation with them, because they aren’t structured to take advantage of this, nor could they be really.
Making Employers More Willing to Offer Annuities Isn’t Necessarily a Good Thing
In addition to the general lack of interest out there, employers have become shy about offering them within their 401(k) plans due to a fear of lawsuits if the insurer’s business fails and their annuity obligations then become unfulfilled.
Removing this concern is needed if we want to expand people’s access to them, and this is exactly what the Secure Act seeks to do, which has already been passed by the U.S. House of Representatives and has moved on to the U.S. Senate. Since this bill is not a contentious one, it is receiving bipartisan support and is expected to pass without much difficulty.
Financial advisors are the only ones that are up in arms about this though, as some see this as better enabling more people to make financial mistakes, which they see the use of immediate annuities within a tax-deferred retirement plan as.
One of the concerns is that this bill does not restrict the inclusion of high-cost annuities, and the feeling is that we should see some regulation surrounding fees included in the bill. This is a good point and there are certainly annuity plans out there what charge excessive fees and this in itself can have a real negative impact on what we get out of our annuities, since they reduce the payout per amount invested and can do so pretty meaningfully in some cases.
There are also calls for regulators to pay more heed to an insurance company’s financial strength, as seeing our annuity payments that we have spent our retirement money on to protect us in the future fail to be made is not a circumstance that can be seen as ever acceptable.
If we are serious about returning annuities to make them more available and serviceable in their use within retirement plans, we really need to consider having them backed by the government the same way that deposits are by the FDIC. The risk is low here as well but the peace of mind that this would buy would be substantial, at a low cost.
This can actually be seen to be even more important than protecting our deposits up to a certain level, and is at least on par with that. The appeal of an annuity, and the sole appeal in fact, is to know that you can count on a certain level of income throughout your retirement years, and not having to worry about your insurance company going out of business would cement this deal.
There is also the matter of giving up control of the retirement assets that you place in an annuity, and this is the side of annuities that can be both a benefit and a cost. Annuities can be cashed in, but if you have to do that, you’ve given up the financial security that you sought with this idea and will end up less well-off than if you had invested your money through traditional means.
Annuities Serve to Protect Ourselves Against Spending Our Money Too Fast
This can be a benefit as well, especially for folks who need to be protected against themselves. Annuities do provide an escape hatch that can be used in times of crisis, but a lot of people spend more of their retirement money than they should on things far less dire, and an annuity can serve to close the gap between what they should spend and what they actually would spend if given the opportunity.
This is the biggest benefit with annuities, and is tied in directly to the financial security it provides. The sole reason why it does provide this security is because it protects us against ourselves and keeps us on the straight and narrow and sees our retirement plans through to the degree that we have committed to it.
Unless you live considerably longer than your life expectancy, you won’t benefit nominally from an annuity, meaning that the money you will get may be less than you put in in. The break-even point for men is at age 65 is around age 80, meaning that you have to live that long just to get your money back, with women needing to live even longer to break even.
If we pass on the annuity, we could have done something with the money to get a return higher than zero, which is a real cost and needs to be added to the sum. At age 80, we therefore break even by getting the principal back but now we have to earn more to get back the returns we gave up for this.
There’s also the matter of accounting properly for inflation. An annuity amount at retirement may look like it’s going to fill the gap between our social security benefits and our spending, but due to inflation, if this is the case then we’re going to experience a bigger and bigger shortfall each year as our spending increases due to this.
This means that we’re going to want to build in these cost of living increases by seeking to get more than we need at the start of our retirement to make up for these expected shortfalls. More in retirement is a good idea of course, but we may not have the means for this, or be able to even come close to what we need for that matter.
The ideal time to buy an annuity is not during our working years though, the sort of thing that this bill is looking to promote. It’s not even a good idea from an overall perspective when we consider the loss of tax benefits, which we must.
There are people who see immediate annuities as a way to escape investment risk, especially folks who have enjoyed great results over the last decade and are afraid that this may all come crashing down. There are more options here than stocks or annuities though, and purchasing an annuity to hedge against stock market risk does not even make sense, given we can just choose a safer place to put our money, including in risk-free treasuries.
Annuities do have their time and place though, but the time to buy them with your retirement money is when you retire, not years or decades in advance. We want to allow our money to grow in our tax-deferred accounts the way that this is meant to happen, and this will allow us to have more money to buy annuities or whatever else we want to spend our money on when the time comes.
Considering an annuity is a big decision and one that impacts our plans pretty substantially, and should always only be made with careful deliberation to ensure that it is truly right for us, or we have at least decided that it is or isn’t to the best of our abilities. This is not a decision that should ever be rushed or treated like a fad should our employer start offering it soon, as they may.