The Ups and Downs of Annuities

For many years, employees who wanted to ensure regular financial payments after retirement had two basic avenues to explore: Either go to work for a company with a defined-benefit pension plan, or invest a portion of their income during their career and continue managing the investment of that money into retirement.

Now, however, the choice isn’t quite as cut-and-dried.

More companies are allowing investors to use their 401(k) payments to purchase annuities, which function much like insurance policies.

Annuities guarantee monthly payment amounts – usually for life – for the purchasers or their chosen beneficiaries, thereby giving employees the opportunity to ensure that they will have a steady income throughout retirement.

There’s also flexibility with annuities, in that the more money participants are willing to spend, the higher the payments will be when they retire.

Financial analysts, however, warn that annuities are dependent on the stability of the company from which they are purchased, which adds an additional level of risk not found with many other investment options.

Alternative to pension

Annuities can be an attractive option, especially for employees of small companies without the wherewithal to offer a traditional defined-benefit pension plan.

“Their employees can retire and set up the annuity as a guaranteed revenue stream for life,” said Rick Hale, certified financial planner with Ameriprise Financial in Springfield, who works with the retirement plans of several employers, including Springfield Business Journal. “They want their employees to be able to have a revenue stream to dovetail in with Social Security and 401(k).”

The increased use of annuities is part of what Hale calls the “most significant change” in retirement investing in the last several years – a shift toward employee control over their own retirement funds.

“More and more employers are allowing employees to choose their investment options rather than choosing for them,” Hale said, noting that there are more options available when choosing how to invest 401(k) funds.

The combination of the regular payments of an annuity and the early retirement age of a 401(k) plan – most plans allow the investor to begin making withdrawals at age 55 – can also make annuities attractive, according to Troy Kennedy, chief marketing officer for Springfield Trust Co.

Individual retirement accounts, meanwhile, don’t allow for penalty-free withdrawals until age 59K.

“You could start taking money out at 55 without the 10 percent penalty, as opposed to an IRA,” Kennedy said.

Kennedy said that the annuity also carries an obvious benefit: It ensures that the investor doesn’t outlive his or her money by creating a steady source of income for life.

Predicting the future

Financial advisers say annuities come with specific challenges, and the biggest by far is trying to predict how much money will be needed in retirement. That amount will, in turn, determine how much should be spent in annuities.

“With an annuity, you start out with the end result – the retirement payments – and the question is whether that end result will be enough,” said Dwight Rahmeyer, CEO of Trust Company of the Ozarks. “Is that money enough to retire on? Are there cost-of-living adjustments built in?”

Choosing the right insurance company from which to purchase annuities also is important, particularly for those investors who follow the advice of analysts and begin planning and saving for retirement at a young age.

“An annuity is backed by the strength of the issuing insurance company, so that’s something you have to be careful of,” Kennedy said. “You might sign a contract, but if the insurance company goes into bankruptcy, your (income) stream is gone.”

Rahmeyer said it takes a lot of legwork to choose the right annuity.

“If you’re a 29-year-old, you’re not going to retire for 35 years, and it would be hard to predict any company’s future 35 years from now,” Rahmeyer said. “As the purchaser of that annuity, you’d want to make sure you stayed on top of that company, checking on them at least every six months.”

Another downside to annuities is the inability pass them on as part of an inheritance. Kennedy points out that when purchasing an annuity, there’s nothing to pass on to dependents after the investor’s death.

“If I invest in an annuity and it pays an income stream for life for me and 50 percent of that for my wife, once we’re both gone, the money goes away,” Kennedy said.

Fees and benefits

Hale said although some “unscrupulous” advisers will tout tax benefits as a reason to use 401(k) funds to purchase annuities, the fact is that all earnings in a 401(k) plan already are tax-deferred.

“You’re not gaining any tax benefits (by using 401(k) funds),” he said.

Much in the same way, 401(k) owners will pay penalties for early withdrawals, investors who want to pull money out of annuities prior to a predetermined date, will forfeit a percentage of the money as a surrender charge.

With annuities, there’s also a mortality expense fee to consider, because although annuities are set up to provide payments for the life of the beneficiary, the money to make those payments comes from investments made by the company that sold the annuity.

If those investments don’t return enough to cover the guaranteed payments, or if the person making the payments dies before they’re eligible to receive payments – and thus, stops making payments to the issuing company before it’s expected – the plan has to include some way to make sure other beneficiaries receive their money. The mortality expense fee is assessed up-front when the annuity is sold.

“Those fees range widely between companies, so a person should always compare those fees against other companies,” Hale said.

The verdict

Overall, opinions are mixed on the idea of using 401(k) money to purchase annuities.

Because 401(k) plans are already a tax-deferred vehicle, Kennedy doesn’t see the point of 401(k) annuities.

“An annuity, in my opinion, is for outside of retirement investments, for a guaranteed income stream for life,” he said.

Rahmeyer said there are other ways to mimic that steady stream of income through retirement, including using layers of bonds and index-traded or exchange-traded funds in a 401(k).

Hale said there are a lot of benefits to the annuity idea – but like any investment option, it should only be part of the portfolio.

“You want to make sure it fits the individual’s investment objectives,” Hale said. “It’s not like it’s a one-size-fits-all for every retirement situation.”