The SECURE Act is primed to make annuities available in more retirement plans. But just because an investment is available does not make it a good idea.
The Setting Every Community Up for Retirement Enhancement Act will affect retirement planning in a variety of ways. I have written in this space about some of the changes it will make to individual retirement accounts. It will also result in many other changes to IRAs, required minimum distributions and employer-provided retirement plans. Among these changes are new protections for defined contribution plan sponsors who offer annuities to participants.
Before the new law, annuities were rare in workplace retirement plans. According to the Plan Sponsor Council of America, as reported by CNBC, only 10% of 401(k) plans currently offer annuity options. In large part, employers avoided annuities out of fear that they could be held liable if an insurer failed to meet its promised obligations. The new law provides safe harbor for plan sponsors who offer annuities as long as they follow specific guidelines for choosing insurers, even if an insurer later goes under. This makes it more likely that employers will offer annuities in their 401(k) plans.
This is a big win for one specific group: people who sell annuities. Annuities are often expensive, which makes them particularly attractive to people who earn commissions by selling them. Brokers often earn as much as 6% or 7% on an annuity sale. It is little wonder that the prospect of more people buying annuities excites them. For investors, however, the change demands caution rather than celebration.
Annuities are designed to provide a steady stream of cash, usually in retirement. While they are often packaged like investments, annuities are better understood as insurance products. The specifics vary, but at their core, an annuity is an insurer’s promise to pay you on a schedule. You give an insurer a particular sum, either all at once or over time. The insurer then makes regular payments for a period of time, often to the end of the annuity owner’s life. In exchange for this certainty, annuity owners typically pay high fees and operating costs, and are subject to steep surrender charges that apply for long periods.
Besides being expensive, annuities are also complex. This complexity means that the word “annuity” can indicate a variety of functionally different products. Common examples are fixed annuities, which pay out at a predetermined interest rate, and variable annuities, which can offer a larger payout depending on the performance of underlying investments. Various types of annuities offer different conditions and rules, and none come cheap. When you factor in all the potential variations in terms, conditions and structures, one annuity may look very little like another. It becomes essential for a prospective buyer to look closely at any individual annuity’s prospectus in advance, though these can often run hundreds of pages.
Most of the time, investors will get a better retirement planning outcome elsewhere. This is because insurers price in the fact that annuity buyers are shifting investment risk to them. Yes, you can lock in a steady payment for life with an annuity – but the rate of return you lock in is generally quite low.
In a low interest rate environment like the current one, the cost of guaranteeing lifetime income is relatively high. This is because insurers don’t stand to earn much from safe, stable investments. And if interest rates rise, you will have locked in today’s low interest rate for many years to come, if not the rest of your life. Locking yourself out of future rate increases would be frustrating on its own, but could be disastrous if inflation starts to rise too. Even though your payout is guaranteed, its purchasing power could fall. If you eventually want out of the annuity, contract terms and the insurer’s surrender fee structure can effectively lock you in for years.
Another serious risk in purchasing an annuity is early mortality. In other words, what if you die much sooner than you expect? Some annuities include a minimum payout if you die before a certain, relatively young, age. But in general, your heirs cannot recoup the excess of the amount you paid into the annuity if you die sooner than you expect. You can add certain riders that may allow for some amount to pass to your heirs in particular circumstances. Annuities structured this way, however, will be even more expensive as a rule. In the end, insurers are businesses, and their goal is to not lose money when they sell annuities.
Annuity supporters argue that, as defined benefit plans continue to vanish, workers need the assurance of a steady retirement payout. But there are other ways to generate a steady income stream. Annuities offer tax deferral, but so do traditional IRAs. In many cases, so do the company-provided retirement plans in which potential investors are already participating. It is true that these accounts do not come with guarantees. But they offer more cost-effective ways to invest, increasing the potential size of your nest egg. Gains on annuities are also taxed as ordinary income, rather than at the lower long-term capital gains rate. This is not to say there are no circumstances in which an annuity makes sense – but in my experience those circumstances are rare and specific.
Before the SECURE Act shielded them, employers did not want to take on the risk of recommending an insurer that could later go bust. But maybe if an employer is convinced that its retirement plan should offer an annuity, that employer should shoulder the blame if the insurer fails, the same way it would face liability if other parts of the retirement plan were mismanaged. The guarantee that makes an annuity valuable is only as strong as the company issuing that guarantee. Insurers have done themselves no favors when it comes to their reputation for honesty and transparency, especially when it comes to annuities. Rules absolving retirement plans from thorough due diligence should make participants more vigilant about their choices.
Of course, just because plans can offer annuities with less risk of being held responsible if they fail does not mean they will open the floodgates. Issues of cost and complexity may limit employers’ appetite for including annuities in their 401(k) or other defined contribution plans. This is especially true for smaller businesses with fewer resources to devote to researching their options. The safe harbor rules do not mean plan sponsors are absolved from their fiduciary responsibilities altogether. Even in plans that do offer annuities, there is no guarantee that significant numbers of participants will want them. Plans will not be able to make an annuity a default option under the new rules, meaning individuals will need to opt in if they want them.
At Palisades Hudson, we rarely use or recommend annuities when planning a retirement strategy for our clients. This is not because they aren’t available. In most cases, annuities are simply the wrong choice. Making annuities available in a 401(k) or other employer-provided plan is a change the average person didn’t need, didn’t want and didn’t ask for.
If you are set on considering the annuity options coming to your 401(k), consult a fee-only financial professional – in other words, someone you know will not earn a commission if you do decide to buy an annuity. Investors should proceed with extreme caution, even as lawmakers gave retirement plan sponsors the all-clear.