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The Pitfalls of Longevity Annuities in 401(k)s

Credit: Flickr user Samdogs.

The unpredictable economy has sparked many discussions about what, if anything, can be done to ensure guaranteed "paychecks" during retirement. In fact, the fear of running out of money in retirement now even supersedes the fear of death, according to a survey by Allianz Life Insurance.

Well, it seems insurance companies are aiming to ease people's fears by offering "longevity annuities" in retirement plans. Here's how they work: 401(k) and IRA account holders can use no more than 25% of their total account balances or $125,000 (whichever is lower) to buy the annuity. Purchasers typically make a one-time premium payment later in life, which in turn allows them to begin collecting guaranteed payments as late as age 85. The size of the income payout adjusts based on how old you are at the time of purchase and how soon you begin taking income.

For example, according to MetLife estimates, a man who pays $50,000 for a longevity annuity at age 50 could start receiving annual income of $43,000 at age 85, assuming an inflation rate of 2.5% per year. If he only waits until age 80 to start taking income, his annual payout is reduced by nearly half to $23,500.
 
This may look like a retirement guarantee at first glance, but in reality, annuities are complex and don't often provide the simple "guarantee" they promise. Annuities are only backed by the claims-paying ability of the policy-issuing insurance company, which may or may not have good financial standing in future years.

Due to the lack of an actual guarantee, among other issues, there have been heated debates over whether this supposed solution is wise and will indeed ease people's fears about going broke in their golden years. Until recently, rules prevented annuities from being widely used in 401(k) plans and IRA accounts, because those accounts come with required minimum distributions (RMDs) starting at age 70-1/2. However, the U.S. Treasury Department and the IRS have recently announced new tax rules that promote a favorable union -- maybe.

Now, a distribution used to buy a longevity annuity is exempt from RMD requirements. This means that you are able to put aside your tax-free dollars for a longer period of time. This may be a tax victory, but whether or not it's a retirement savings win is doubtful, because not many retirement plan administrators find them favorable enough to offer them.

However, if you are offered a longevity annuity, be sure to do your homework before signing on the dotted line. Ask the following questions.

What insurance company is guaranteeing this plan? What happens if that company goes bankrupt?
There is currently no federal program in place that protects consumers from insurance-company bankruptcies similar to how the Federal Deposit Insurance Corporation (FDIC) helps protect account holders against bank failures. Be sure to inquire about the possibility of a state guarantee from the Insurance Guaranty Association.

What happens if I die before my first payment?
If you die before you start receiving payouts, the entire balance of your account will be lost. In that case, the insurance company would likely take control of the money in your account. Some companies offer additional coverage in the form of beneficiary riders. With this rider in place, your beneficiary will still receive some type of payment upon your premature death. However, some only provide for a return of the premium (or money) you invested.

For example: Assume you are 65 today and put in a lump sum of money in order to guarantee an annual payout 20 years down the line. Unfortunately, you pass away at age 84 -- one year before those benefits kick in. If your policy has a "return of premium" rider, your heirs would get back only the money you invested, and that's it. You've just given an interest-free loan to the insurance company for 19 years!  

Will my payments keep pace with inflation?
Annuity payments are based on today's interest rates. As a result, today's annuity purchasers may be buying very expensive annuities unless interest rates remain stable or decrease during the term of the annuity payments; this is generally an unlikely outcome, though interest rates will probably be higher in 10 or 20 years than they are now. Any future increase in inflation will erode the purchasing power of an annuity purchased today, unless that annuity adjusts for inflation -- this is an available feature, but it's somewhat expensive.

At the end of the day, the most important thing is to reach your retirement goal in the most efficient, least restrictive manner. On the surface, annuities may seem like a good tool to include in your portfolio, but if you look closely, you may find that they have no place in your retirement planning. A professional investment advisor can help you decide whether a longevity annuity makes sense for you and your portfolio.

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