Annuities are making a comeback of sorts, with a small but increasing number being offered to employees as "guaranteed" investments in employer-provided 401(k)-type defined contribution plans and in executive retirement plans.
In some circles, a traditional variable annuity product never really disappeared. In the world of qualified retirement plans, however, such vehicles have long been seen as costly and complex insurance products in comparison with less expensive mutual funds, collective trusts and or other more-familiar investment vehicles.
The renewed interest in annuities is coming about for several reasons:
• The 2008 and 2009 securities market meltdown caused a real crisis of confidence in the stock market. Investors on Main Street simply distrust Wall Street.
• People are more worried than ever before about out living their retirement nest eggs. Some retirement planners now believe that a portion of a person's retirement portfolio needs to be in a product that hedges against longevity and literally cannot be outlived.
• Insurance carriers have developed a litany of supposedly "new" annuity products with some interesting bells and whistles. Indeed, these new designs have a lot of sales appeal. But as the old expression goes, buyer beware. Or perhaps in this instance, the buyer mainly needs to be aware of the benefits and potential drawbacks of these products.
In February 2010, The U.S. Department of Labor (DOL) and the Treasury Department issued a request for information seeking public comments on enhancing employer-sponsored defined contribution plans through annuities and other options that provide an income stream after retiring. The comment period closed on May 3, 2010. Forthcoming guidance is expected at a future date. Comments received by the agencies can be read here.
Annuities are contracts between a person or persons and an insurance company, and may be classified in a number of ways.
Qualified or nonqualified. With regard to federal taxes, annuities are classified as qualified or nonqualified. To be qualified, an annuity must be purchased as part of, or in conjunction with, an employer-provided retirement plan, or an individually provided qualified retirement arrangement, such as an individual retirement account (IRA). If all the necessary legal requirements have been satisfied, contributions made to qualified annuities should be wholly or partially deductible from the taxable income of the individual or the employer.
On the other hand, a nonqualified annuity is not part of an employer-sponsored qualified retirement program. Contributions to nonqualified annuities are often provided with executive deferred compensation, and are typically made with after-tax dollars. In the world of executive compensation, it is not uncommon for a so-called secular trust (an after-tax "rabbi trust," which is an irrevocable trust for deferred compensation) to be paired up with a nonqualified annuity product. It should be noted that dollars used to purchase a nonqualified annuity are not deductible from an individual's gross income.
Fixed or variable. Another classification for annuities depends on the type of investment or type of payout. The oldest type of annuity is a fixed annuity, which in its simplest form provides a stream of payments that never changes over a lifetime. Fixed annuities come in many flavors. They can be indexed for inflation and they can provide an annuity stream for both the holder and spouse. Most of these add-ons come at additional cost.
Variable annuities, by contrast, have investment subaccounts that resemble mutual funds. The income these annuities pay is not fixed, and will rise and fall with the underlying investments.
New to the field are equity-indexed annuities, which look like a hybrid of fixed and variable. They are tied to an index, typically the S&P 500 index of large U.S. stocks. The annuity will benchmark the index, but limit its effect, both on the downside and upside.
The downside limit is the lowest amount the contract will pay, which could be as little as nothing. The limit to the upside is called the participation rate. If the S&P 500 rises 8 percent in a year, and the participation rate is 75 percent, the rate earned will be 6 percent (8 percent x 75 percent = 6 percent).
In addition to the participation rate, another type of limit is known as a cap. Assuming a contract has a cap of 10 percent, if the S&P 500 rises more than 26 percent as it did in 2009, gains are limited to 10 percent. On the other hand, if the S&P 500 drops 37 percent as it did in 2008, the holder will still receive the minimum rate of return.
Pros and Cons
Annuities that come with interest rate guarantees are very appealing in unstable times. Financial planners, as well as individuals who desire to protect against a loss of principal, have been using immediate fixed annuities for years to buy a pension for clients without defined benefit pension plans. In addition, deferred fixed annuities that are triggered at a client's age of, say, 80 or 85, can serve as a protection against running out of money in old age.
Annuities are not a panacea, however. Some annuities have surrender charges that can persist for as long as 10 years. Other annuity contracts carry very stiff financial penalties if they are surrendered after only a few years. Annuity contracts contain a lot of fine print, so buyers need to read every word of it to know what they're getting.
In addition, annuities can be much more expensive than a typical securities investment. For example, equity-indexed annuities can cost 3 percent or more a year, whereas the average expense ratio of all 26,458 mutual funds monitored by Morningstar is 1.32 percent, or less than half of that.
Finally, it is important to understand that annuities are backed by the good faith and credit of the insurance carrier that issued the contract. In other words, an annuity is only as good as its issuer. If an insurer gets into financial difficulty and is unable to meet its contractual obligations, the money invested in it might be at risk. Since an annuity may need to provide retirement income for more than 30 years, this is a key concern.
In summary, annuities, particularly fixed and equity-indexed varieties, can provide both stability and protection in an uncertain world, but plan sponsors considering adding annuities to the investment menu should:
• Understand the costs.
• Know the surrender charges or penalty fees.
• Read the fine print.
• Check the ratings of the issuing companies from the ratings agencies such as Standard & Poor's, Moody's, Fitch, and A.M. Best
Paula Boyer Kennedy is vice president, Investment Services, at Cammack LaRhette Consulting. Mark B. Manin is president of the firm.
This article is for general informational purposes only, is not intended to be taken as legal advice or a recommended course of action in any given situation. Readers should consult their own legal advisor before taking any actions suggested in this article.
Annuities and Retirement Savings, SHRM Video, June 2010
DOL Seeks Comments on Lifetime Income for Retirement Plans, SHRM Online Benefits Discipline, February 2010
401(k) Distributions: Easing Into Annuities, SHRM Online Benefits Discipline, June 2008
The 401(k) Annuity Rollover Option at Ericsson, SHRM Online Benefits Discipline, June 2008
401(k) Annuities: An Idea Whose Time Has Come?, AARP Bulletin, June 2010
Lawmakers Seek to Extend Income as Americans Outlive Savings, Bloomberg BusinessWeek, June 2010
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Treasury, Labor Get Earful About Annuities, National Underwriter, May 2010
GOP, Dems Clash over Modifying 401(k) Plans, San Francisco Chronicle, May 2010
DOL Fact Sheet: Lifetime Income Options for Retirement Plans, February 2010
The Unloved Annuity Gets a Hug from the Obama Administration, New York Times, February 2010
SHRM Online Benefits Discipline