Does an Annuity Belong in a 401(k)?
Unlike pensions, 401(k)s place the risk of outliving savings squarely on the retiree's shoulders. Find out what's right for you.
When 401(k)s began replacing private employer pensions decades ago, employees lost a crucial piece of their retirement plan: a guaranteed lifetime income stream. Unlike pensions, 401(k)s place the risk of outliving savings squarely on the retiree's shoulders.
As part of the Setting Every Community Up for Retirement Enhancement Act, Congress encouraged 401(k) plans to offer annuities. "An annuity is insurance for your lifetime income, sort of like your own personal pension," says Philip Maffei II, TIAA's managing director of corporate retirement income products.
If you're near retirement and want an annuity, buying one through a 401(k) has advantages, but variety isn't one of them. Most 401(k)s offer only an immediate fixed annuity, which starts paying income right away for the rest of your life. If you want another type, like a variable annuity with market exposure for potentially higher growth or a deferred annuity, you'll likely need to buy it outside the plan. Here's what else you should consider.
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The Heavy Lifting Has Been Done
Employers have been reluctant to include annuities in 401(k)s, fearing they would be held liable in the rare instances that an annuity company goes bankrupt. The SECURE Act protects plan sponsors from liability provided they follow federal guidelines for selecting viable insurers. For example, an employer must consider the annuity company's credit rating, financial health, and the fees relative to the benefits paid to employees. Companies must have met the state's requirements, including maintaining enough reserves, for the past seven years. Those protections also help employees. "You've got a sophisticated expert reviewing the products first," says Sri Reddy, senior vice president of retirement income at Principal Financial Group.
Group Pricing May Be a Better Deal
Although the plan is not required to go with the cheapest provider, "in general, large group pricing leads to a better deal than the individual markets," says Maffei. For women, there's an additional advantage. "Annuities in a 401(k) must use unisex pricing," says Wade Pfau, a professor of retirement income at The American College of Financial Services. In the individual market, companies can charge different rates based on gender. "This is good for women inside the plan as they tend to live longer. It's not as good for men, relatively speaking, who may find a better option outside the plan," says Pfau.
You Can Keep Your Annuity Even If Your Employer Doesn't
In the past, if your employer switched annuity providers, you may have had to switch too, losing your existing benefits and guaranteed income stream. Now, when the employer changes providers, you can keep the annuity and "roll it over to an IRA to preserve your benefits without any incremental fees," says Reddy.
You'll Have a Better Idea of Your Income
Whether they offer annuities or not, plan sponsors are required to estimate how much guaranteed lifetime income your account balance could potentially generate if you bought an annuity, helping you determine if one is worthwhile. You should get an estimate for your life and a joint life estimate if you're married.
You May Be Able to Transfer Funds
One obstacle to buying an annuity in a 401(k) is that your retirement savings may be scattered in different accounts. "Most employees move pockets of savings into an IRA as they change jobs," says Reddy. "They might not have enough in their current 401(k) to properly fund an annuity." Some companies may allow employees to transfer other retirement funds into the 401(k) using a rollover, but retired employees won't have this option, even if they still have money in the 401(k).
The Clock Is Ticking If You Have Second Thoughts
Unless the plan offers something other than an immediate annuity, you are locked in once you buy it, though Reddy says you will have at least a 30-day free look period during which you can back out of the contract. "Once you begin to receive lifetime income payments, you cannot change your mind," Maffei says.
The Income Is Taxed in Full
Because you used pre-tax dollars to buy the 401(k) annuity, 100% of that income will be taxable. When you buy an annuity outside of the plan using after-tax dollars, part of your payments are tax-free as the company returns your original contribution.
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