Employer pension plans are rapidly disappearing, making retirement savings critical.  The risk is that people will outlive their savings. Those nearing retirement, as well as the federal government and some plan sponsors, would like to find a way to turn 401(k) plan accounts into a lifetime stream of income. Some employers have incorporated annuities into their defined contribution plans as an option for participants, and a few commentators have suggested that 401(k) plans should be required to include an annuity option.

One reason that employers have been reluctant to add an annuity option is that they have found little demand from plan participants. Demographics can play a significant role here. The young workforce of a hi-tech firm, for example, most likely will have little interest in annuitizing. However, a company with an older workforce that has been contributing to a 401(k) plan for many years will have a greater incentive to add an annuity option to its plan.

For the participant, the question is:  when you retire, would you prefer a guaranteed rate of return on your retirement funds and a regular payment, or would you choose a potentially higher return on a lump sum payout subject to the risks of the markets? Some people looking ahead to retirement would take the guaranteed payout. Current uncertainty in today's markets may have a lot to do with that.

Other annuity-type approaches are available, such as using a 401(k) account like an annuity as part of a Social Security "bridge option" strategy.  An individual could elect to receive a larger monthly payment out of a plan upon retirement and postpone receiving Social Security payments until he or she is eligible for the maximum benefit.

The Labor Department is encouraging participants to think about annuities in its lifetime income project. Reportedly, the agency is working on a proposed regulation that would require that defined contribution plans include in benefit statements an illustration of the participant's benefit in annuity form. 

Making retirement assets last a lifetime requires careful planning, discipline and a fairly thorough understanding of life expectancy and rate of return.  Annuities are complicated and people are concerned about a loss of control over their retirement assets.  Some workers are concerned that the whole purpose of the annuity will be defeated if they don't live long enough to receive a significant payout. In addition, lack of portability may be a problem. If a participant invests in a delayed annuity product, then moves to a different employer and pulls the money out of the investments, the expenses that the participant paid may be lost. If the participant leaves the money in the annuity, the participant would be in multiple plans that would have to be tracked and managed.

Are Annuities the Answer?  

While annuities inside a 401(k) can be used to fund retirement while limiting investment risk, anyone considering an annuity, inside or outside of a 401(k) plan, should take into account cost, transparency, the solvency risk of the entity making the annuity payments and whether the annuity contract is portable.

As with every financial decision, the costs should be weighed against the benefits. Annuities can be costly once annual maintenance fees and other charges are factored in. It's possible that an employer could negotiate lower fees or agree to absorb some or all of those costs on behalf of its employees. Of course, a retiree can purchase an annuity with funds rolled over from a 401(k) into an IRA, but the costs can be prohibitive, especially if the retiree does not have a substantial account balance. Also, there is no tax incentive to counterbalance the cost. Money builds up tax free inside a 401(k) plan, and the amounts paid out of an annuity contract are taxed in the same way as the amounts coming out of a retirement plan.

Another objection is that investment choices may be limited, although workers approaching retirement generally are more interested in protecting their retirement assets than in growth and may be satisfied with a limited range of investments.  

A concern of both employers and employees is the solvency of the insurance company promising to pay the annuities. Employers need to choose carefully, using all of the information available to them as this choice could result in fiduciary liability.

Flexibility Would Help  

Annuity products that allow for more flexibility and resolution of certain tax issues might help employers as well as participants feel more comfortable with annuities. Insurance companies are introducing partial annuities and delayed starting dates. Also, some new products let an annuity owner withdraw money or reserve a certain amount for heirs. Some tax issues -- such as transferability conditions, spousal rights, minimum required distributions, rollovers and tax reporting -- could be clarified by the IRS.

If participants ask for it, employers may be more willing to add an in-plan option despite the relative complexity of administration and fiduciary issues involved in choosing the type of product and the annuity provider.

By Sharon F. Fountain, Managing Editor for Compensation Planning