Does an income annuity belong in your 401(k)?

The U.S. Treasury Department and the IRS issued guidance last week that aims to expand the use of income annuities in 401(k) retirement plans. The guidance clarifies for plan sponsors how they can include deferred income annuities in target-date funds.

These funds are commonly used as a default investment option where participants are automatically enrolled and make no other investment elections on their own. According to the guidance, if an annuity is included in the plan, it would be voluntary for plan participants.

In a statement, Deputy Assistant Secretary for Retirement & Health Policy Mark Iwry said: "As boomers approach retirement and life expectancies increase, income annuities can be an important planning tool for a secure retirement. Treasury is working to expand the availability of retirement income options for working families. By encouraging the use of income annuities, today's guidance can help retirees protect themselves from outliving their savings."

The stakes for this guidance couldn't be higher. According to the Investment Company Institute, 401(k) plans hold an estimated $4.4 trillion in U.S. retirement assets and represent 18 percent of the $24 trillion of total retirement assets in the U.S., which includes pension plans, IRAs and annuities.

But some folks are concerned that this is the wrong time to be issuing guidance that encourages plan sponsors and their service providers to offer income annuities in retirement plans.

That concern appears to be well founded. A critical component of calculating the monthly income from an annuity is the interest rate, or discount rate. Interest rates are at historical lows. Twenty years ago, the yield on the 10-year Treasury was around 7.25 percent, but today it's about 2.25 percent.

If a person age 65 bought an income annuity with an internal interest rate of 2.25 percent, the income would be about $518 per month. If the interest rate was 7.25%, the income would be about $790 per month, or 52 percent more. Anyone with a time frame longer than seven to 10 years and some common sense would conclude that buying an income annuity now doesn't make sense.

What the feds may be impressed with, and I suspect others are as well, are the annuities' "guaranteed income for life." But at today's low interest rates, the monthly income provided would almost entirely be just a return of principal. That's a lousy rate of return.

And who's going to guarantee the guarantor of this wonderful income for life? Specifically, participants who buy these products they need to know that no matter what happens, that income will always be there.

If insurance companies or other financial institutions provide these annuities, a contractual guarantee is not enough. They need some other backstop such as the role played by the Federal Deposit Insurance Corp. for savings accounts and the Pension Benefit Guaranty Corp. (PBGC) for traditional corporate pensions.

Another concern is that retail insurance-based products would be too costly. In-plan annuities should be institutionally priced (that is, lower priced than retail annuities), and they should not have commissions, surrender charges, retail-type fees, charges, etc.

Whether reputable financial companies will create institutionally priced annuities, whether a plan will actually offer such an option and whether participants will buy these in their 401(k) is another story altogether. But with trillions of dollars worth of assets in participants' retirement plans and financial companies salivating over another product to sell, I'm very skeptical of any product available in the market today.

If these in-plan income annuities allow individuals to use their existing 401(k) dollars and/or to allocate their new contributions to purchase a defined amount of lifetime income to start at a specific age, this is essentially adding a defined-benefit feature (like a traditional pension plan) to a defined-contribution plan (such as a 401[k]).

While that's an interesting option, it would need to be carefully explained to participants so that they understand what's involved and how they differ from true defined-benefit plans, which have an existing framework including funding requirements and insurance for benefits up to a stated amount under the PBGC.

Rather than adding annuities in a 401(k) plan, employers that offer retirement plans should take a look at how the Federal Reserve Bank allows participants in its retirement savings plan to purchase additional lifetime retirement income benefits.

The Fed allows participants in its Thrift Savings plan -- a 401(k)-type plan -- to purchase additional monthly income benefits by making a transfer to its Retirement Plan -- a traditional defined-benefit plan -- under what it calls a Pension Purchase Option, or PPO. Such transfers are allowed once a year during a special enrollment period. They're tax-free and irreversible. Maybe this approach is a better solution?

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.