EDITOR'S NOTE: This article was originally published in the April 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.
Fear of a market downturn right before retirement is leading to record sales of annuities with income guarantees. With these products, you invest in mutual funds but are promised a minimum income stream every year in retirement for life, even if the market falls.
But most workers don't have this option in their 401(k) plans. They generally have to use money in a taxable account or an IRA to buy these annuities. That's beginning to change, though.
David DeBell is in the vanguard of workers who can build a pension-like guaranteed income stream in their private-employer retirement plans. In June 2007, his company's 401(k) provider, Prudential, introduced its IncomeFlex product to employees. DeBell, then age 62, jumped in. "Personally, this was a good deal," says DeBell, who recently retired as vice-president of human resources for a manufacturer of heating and air-conditioning systems in Westfield, Mass. As head of benefits, he helped select the company plan.
The timing was perfect. IncomeFlex gave him a choice of five fund portfolios and promised lifetime income based on the highest value of the portfolio that he chose. When the market crashed in 2008 -- and his investments lost about $30,000 -- his guarantee remained the same. Even four years later, his account's guaranteed value is worth more than the actual investment value. The bigger nest egg gave him the confidence to retire at age 65 and build a dream home with his wife, Becky, in Hendersonville, N.C. "This has been tremendously valuable to me," says DeBell. "Otherwise, I would have had to change my plans."
Until recently, most employers were reluctant to offer such products in their 401(k)s. Employers worried that employees would lose the guarantees they had built up if they switched jobs and wanted to roll their accounts to another 401(k) or to an IRA. Employers also were concerned that if they ever changed outside 401(k) administrators, employees would lose their guarantees. Plus, employers didn't want the legal responsibility, and possible lawsuits, if the 401(k) annuity provider developed financial trouble in the future and could no longer make good on promises.
Moreover, employers believed that employees would have a tough time understanding these complex products without the support of a financial adviser. "I think there is a real valuable role for an annuity to play as a piece of the overall puzzle. But we need engaged participants to evaluate their options," says Jeffery Acheson, a partner with Schneider Downs Wealth Management Advisors, in Columbus, Ohio, which advises individuals and employers on their retirement plans.
A few new developments, however, have made employers more willing to offer these products. Insurers that offer the annuities now also offer rollover IRAs specifically for the guarantees. Someone who leaves an employer can roll the annuity into this rollover IRA to preserve the guarantee, and move the rest of the 401(k) money into a traditional or Roth IRA. Also, under recent agreements among industry groups, if an employer switches to another 401(k) administrator that offers new investment options, the earlier insurer will honor the older guarantees.
The Growing Market for 401(k) Annuities
The annuities that insurers are offering for 401(k)s are much simpler, and often less expensive, than their standalone products. Prudential, for example, has tied its 401(k) guarantees to its retirement target-date funds. But the guarantee -- and the extra 1% fee on that part of the account -- will not kick in until ten years before the fund's target retirement date. "We believe you need to pay for a guarantee when it makes most sense for you, and that is typically not until ten years before retirement," says Srinivas Reddy, senior vice-president of institutional income for Prudential.
At that point, the guarantee will be added to your investment in the target-date funds. Say you're 55 and you allocate $250,000 of your 401(k) to the annuity tied to Prudential's target-date funds. If you decide to start tapping the account at age 65, you will be able to receive minimum lifetime income of $12,500 a year (5% of your initial guarantee amount).
If the value of your investments increases, your lifetime income guarantee can rise, too. For example, your annual payouts will rise to $16,250, if your investments increase to $325,000. Your lifetime income will be based on the highest value of your investments, measured on your birthday each year, even if the value falls later. It can always rise if your account value becomes greater than your guaranteed income base. Some 401(k) sponsors now offer Prudential's guarantee paired with other companies' target-date funds, such as those offered by Fidelity Investments and Vanguard.
Lincoln Financial has a similar product but gradually phases in the amount of the investments covered by the guarantee -- and the fee -- starting ten years before your target retirement date. You will not pay the full annual fee on the guarantee until you reach your target retirement date. Depending on the plan, the guarantee costs up to 1% of the money invested in it.
In a different approach, Hartford Life offers a fixed guarantee. While you're working, you buy income shares, which lock in guaranteed monthly income in retirement. The shares are separate investments and are not tied to any fund. One income share equals $10 in guaranteed monthly income beginning at age 65. (You'll get more monthly income if you wait until you are older to collect.) The younger you are when you buy the income shares, the less expensive they are: In January, a 50-year-old could pay $1,011 for one income share, and a 55-year-old could pay $1,263.
Pat Harris, Hartford's director of product management for retirement plans, recommends investing just enough in the annuity to cover income gaps. You then invest the rest of your money in funds offered in your 401(k). "It's designed to be only a portion of a diversified portfolio," Harris says.
A big downside to investing 401(k) money in an annuity is that your only choice is the product your employer selects. If you want a guarantee but you don't like your employer's annuity option, you can wait until after you leave your job, roll your 401(k) money into an IRA and use part of your money to buy a standalone version. Among your options are new low-cost versions from Fidelity Investments and Vanguard.