Should Your 401(k) Be in an Annuity?

Statistics indicate that a growing number of 401(k) plans in America are either housed entirely inside a variable annuity contract or else offer it as an investment alternatives. However, this practice has been the source of debate among both financial professionals and regulators for many years. There are many pros and cons for employers to consider when deciding whether or not to offer, or invest in, a group annuity contract inside a retirement plan.

Insurance 

Financial planners and investment professionals who spouse the use of variable annuity contracts inside 401(k) and other tax-deferred retirement plans usually base their argument on safety. After all, the two largest assets of most middle-class households are the house and the 401(k) or other employer-sponsored plan. But homeowners are required to carry insurance on their houses by most mortgage lenders, if not by state law. Therefore, why not insure their future retirement security as well?

Variable annuity contracts can provide this protection inside any type of defined-contribution retirement plan, not only through their regular payouts, but through death benefit riders that can guarantee a minimum payout or contract value under certain conditions. This can be a huge advantage to a worker who has accumulated substantial assets and is retiring in a down market.

Market Protection

Someone who purchased an income benefit rider inside the annuity contract in their retirement plan could enjoy an income stream based on a guaranteed rate, even if this payout far exceeds that which could be generated from the actual balance in the plan. Recent market turbulence has only served to strengthen this argument; millions of workers nearing retirement nationwide have discovered that their plan balances are now too low to provide them the income they need when they stop working. Furthermore, in addition to providing protection to your beneficiaries, the variable income stream provides an inflationary hedge.

Portfolio Rebalancing

Most variable contracts now offer dollar-cost averaging programs that place the initial balance of the contract inside a fixed account that pays a high rate of guaranteed interest. The assets are then reallocated inside a preselected mix of mutual fund subaccounts and moved into these funds on a systematic basis, such as in equal portions over six or 12 months.

Another common feature is portfolio rebalancing, which starts with a set allocation of assets among the various subaccounts of the contract according to the investor's objectives and risk tolerance. Then the portfolio is periodically rebalanced on a regular basis, for example, every month or quarter. Shares of better performing subaccounts are automatically sold and the proceeds used to purchase shares of underperforming funds, thus preserving the investor's original asset allocation.

Comparable services by professional money management firms can cost up to a percent or two of assets, while these features are included in the costs inside most variable contracts offered by major carriers today. (

Cost

Detractors of using variable annuity contracts inside retirement plans usually cite fees as the main detriment to this strategy. Although the income and death benefit riders can provide important protection to plan participants, these measures of security come at a cost that can substantially reduce the investment gains in the plans.

Guaranteed riders can cost over 1% of assets per year, and variable annuity contracts contain other fees and charges as well. Most contracts also charge an annual maintenance fee if the contract balance becomes less than specified limits. All variable contracts also charge a mortality and expense fee of up to 1.6% that covers the general insurance protection in the contract, such as the guaranteed lifetime payout provided the retiree annuitizes the contract. Annuity contracts also usually contain a back-end surrender charge schedule that can last for several years and charge as much as 7-10% in the first year, although they may also allow for limited withdrawals in the first years without penalty.

Tax Deferral

Another common complaint is that the tax-deferred status inherently accorded to all annuity contracts fails to provide any additional benefit, since all defined-contribution plans are already tax-deferred by nature. Annuity contracts can also pose limitations on the investment choices available to plan participants, as only the subaccounts that exist within the contract can be used. Retirement plans that do not use annuities may have a much wider range of alternatives in some cases, depending on the platform and custodian.

Annuities may be particularly useful for older employees who are nearing retirement and need to think about protecting their assets more than making them grow. Younger employees who have more than 10 years to go before retirement may find the additional costs of the insurance riders to be a real drag on their portfolio performance.

Contracts can also vary substantially in terms of costs and fees, as well as the selection of investment subaccounts and their performance over time. Employers should weigh the costs and fees against the historical performance of the subaccounts in a given contract, and also take into account the demographics of their employees. Companies with a large percentage of older workers may be more attracted to a plan that provides some insurance protection against market downturns, while firms with predominantly younger employees may consider this unnecessary.

(Even so, variable annuities can be helpful no matter how old an investor happens to be: See read Variable Annuities: They're Not Just For Seniors.)

There are many factors to consider when evaluating the effectiveness of variable annuity contracts inside 401(k) and other tax-deferred retirement plans. However, the real issue is whether the cost of the features and services provided by a given contract are justified by the benefits received. A comprehensive analysis of contracts and plans available from several different carriers, as well as a comparison of other non-annuity plans, may be necessary in order accurately determine the best course of action for a given company.

Employees who are not sure of what features and riders they should employ in their plans should consult their financial planner or human resources advisor.