The SECURE Act: Is Putting Annuities in a 401(k) Plan a Good Thing?
David K. Little, CFP®, CFA
The House of Representatives passed the SECURE (Setting Every Community Up for Retirement Enhancement) Act in May of this year, and it’s now up to the Senate to decide whether to pass it and send it along to the President. Over the last couple of years, the Senate has passed bills with similar provisions, so it might try to incorporate some of those provisions into the final bill that makes its way to the President’s desk. At this point, it looks like the President is likely to sign whatever bill reaches him after the Senate has approved it.
One of the provisions in the act would allow companies to offer annuities in 401(k) plans. Under current law, 401(k) sponsors are very concerned about potential litigation should one of the insurance companies they bring on board go bankrupt. The SECURE Act would protect the plan sponsors if this happened, so the thought is that the companies will be much more likely to offer annuities than they have been.
But is this a good idea?
What Are Annuities?
First, some background on what annuities are:
Annuities are contracts backed by insurance companies. Stage agencies closely regulate insurance companies and have funds set up to cover bankruptcies of such companies. This makes insurance companies close to risk-free—but not completely. In the case of another financial crisis, all bets are off.
In the contract of an annuity, you’ll see the terms of the annuity spelled out. Those terms typically include interest rates (current rates and guaranteed rates), surrender charges (yes, you usually must pay to get out of an annuity early), and settlement terms (annuitization options), among other things.
Annuitization is the process of converting an asset to a stream of guaranteed income that you can’t outlive. So, if you annuitize your asset and die in one year, you (or your heirs) lose, since you received a payout for only a year. If you annuitize your asset and live to 105, as one of our clients recently did, you win (since the insurance company will make payments to you for as long as you live).
When most people hear the word annuity, they typically think of annuitization, but in actuality, most contracts are never annuitized.
7 Annuity Facts to Consider
With that background in mind, here are seven things we’ll be considering as we make recommendations to people if the bill passes and if companies start to incorporate annuities into their 401(k) plans.
1. Very, very few people annuitize their assets for retirement income. So, although annuities are promoted as a source of lifetime income, most people never use them in a way that provides that advantage. Even people who own annuities tend to hold them and then take withdrawals from them over time, as opposed to annuitizing the balances in the account.
2. Most people don’t calculate what an annuity will earn over their lifetime. Most investors’ eyes light up when they hear about a “risk-free” investment (see above discussion), but they fail to figure out what they can earn on the investment.
3. The majority of annuities are sold, not bought. This means that people don’t ask for annuities. They typically are told (usually by an insurance agent) that they should buy the annuity, and for whatever reason, they believe this. Our firm usually sees this as a result of meeting with people who tell us they have an annuity but wish they wouldn’t have bought it. We come into the picture to help them figure out how to get their money out of the annuity.
4. Annuities tend to be restrictive in their terms. Many annuities we’ve seen have surrender periods of up to 10 years. This means that if you take your money out of the annuity before you’ve owned it for 10 years (“surrender” it), you pay a penalty. We don’t like people to own investments that are illiquid.
5. Annuity terms tend to be opaque. So, if we’re analyzing whether an annuity makes sense for someone, we’ll want to see the terms and understand them thoroughly. Many annuities are sold as alternatives to the stock market, where the purchaser gets “to take advantage of the upside of the stock market, WITHOUT THE DOWNSIDE RISK!!” These claims usually turn out to be unobtainable, since there’s no such thing as a free lunch in the investing world. The “crediting method” (another mystifying term in the contract that means how they calculate your earnings) will usually not allow you to earn anything close to what the stock market earns, especially after you factor in the (usually) high costs of the annuities themselves.
6. Insurance companies are very good at making something they’re selling look good. There is indeed a place for insurance in people’s lives, but there aren’t as many places as insurance companies would have you believe. We recently reviewed an insurance proposal for a client that, on its face, looked great (even the agent seemed to believe in the product wholeheartedly). But after we delved into the numbers, it turned out to be nothing but a run-of-the-mill insurance policy dressed up to look like something that would pay for nursing home expenses. When marketing departments work hard, they usually bring in scary things like medical expenses, nursing homes, and incapacity.
7. Finally, we recognize that annuities are, at times, a good option for people. They can make up part of a diversified portfolio. We recently did recommend that a retiree take the annuity as a settlement option associated with his retirement plan. But that will be a relatively rare case. In most instances, the first six items will carry more weight with us as we make our recommendations following the SECURE Act.
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