In 1978, the Boston Celtics drafted Larry Bird and the 401(k) came to life with the Revenue Act. Despite the fame that followed for Bird, the 401(k) has arguably outshined him by amassing $4.7 trillion in retirement savings for Americans.
Before the 401(k), Americans looked to pensions, along with Social Security, to keep them afloat in retirement. Properly funded pensions guarantee a lifetime stream of payments, which is a nice security blanket for any retiree. But pensions have drawbacks, one being that pension beneficiaries have no control over how the money is managed over time.
The transition to 401(k)s in the 1980s and beyond shifted that control back to savers. With a 401(k), you make the saving and investing decisions, and then you live with the consequences. That style of retirement savings works well for some and not so well for others. The good news is that you may soon have more leeway to mimic the security of a pension from within your 401(k). The SECURE Act, signed into law in December 2019, makes it easier for 401(k)s to offer annuities as investment options. Annuities are insurance products that, like pensions, offer guaranteed income and protection from the ups and downs of the stock market.
Annuities: the basics
An annuity is an insurance product. You pay a premium to the insurer in return for an income stream that's guaranteed. It might be guaranteed for a specified term or for life. If you're worried about outliving your savings, that might sound pretty amazing. But annuities have their flaws. Namely, they are expensive, complicated, and have no federal insurance protection.
- Fees: Annuities carry some heavy fees that affect what you get in return for paying your premium. Experts argue that you usually get higher returns by investing your money in low-cost mutual funds compared to paying an annuity premium.
- Complexity: Annuities come in different forms and have confusing features. You can easily go down a rabbit hole of annuity options that only a statistics whiz would understand. The more confusing the agreement, the more likely you'll get stuck with fees or restrictions you didn't expect.
- Protection: The FDIC protects your cash savings accounts and the SIPC protects your brokerage accounts. There is no equivalent form of federal protection for insurance companies. The protection is at the state level and comes from the state's guaranty fund. You are only protected if the insurer is licensed in your state.
Choosing annuities for retirement savings
Before you jump into an annuity, research the fee structure. Pay attention to management fees, guarantee fees, and surrender fees. Surrender fees are collected by some annuities if you sell your position before a specified period of time.
You should also understand the timeline of the annuity. You might have the option to buy shares in an annuity fund over a period of time. Then, at some later date, you would lock in the income stream using the shares you've accumulated. Or, you might hand over a lump sum for a stream of payments that begins immediately or at your retirement date.
Be sure to confirm what happens to your annuity if you die early. 401(k) assets are transferred to your beneficiary once you die, but the annuity payments might end at that time. If your lifespan is shorter than expected, that's a great deal for your insurer and a bad deal for your heirs.
Lastly, only choose annuities from reputable insurers. The SECURE Act provision that may usher annuities into 401(k) plans protects employers if the annuity provider doesn't pay as promised. That could increase the chances that 401(k)s will offer products from less reliable insurers.
Annuities for diversification
Annuities aren't a slam dunk for retirees, mostly because they're pricey and complicated. But if you understand the trade-offs compared to mutual fund investing, you might appreciate the guaranteed income as a supplement to Social Security.
Of course, the prerequisite to any retirement investment is having money to invest. Make sure you're contributing at least 10% of your income to your 401(k) now. Here's your inspiration: It took Larry Bird 13 seasons as a professional basketball player to score 21,791 points. Save consistently over time if you want to be a retirement all-star.