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401k Fiduciary Warning: 3 Reasons Why Annuities May Increase Your Liability

September 28
14:16 2009

One of the biggest problems facing the 401k fiduciary lies not in making a deliberately thought-out novel decision, but in mindlessly following the herd. Just as the dangers brought by target-date funds have become all too apparent (unfortunately for some, only in hind sight), moreover, so does any “investment de jour” bring with it hidden liability and peril for the fiduciary.

Check this out: The Arizona Republic just posted an article with the headline “Annuities likely next for 401(k)”. Writer Russ Wiles, reporting from the Profit Sharing/401k Council of America conference in Scottsdale last week, wrote “many experts see rising use of annuities as the next innovation” in 401k plans.

Who were these “experts?” Annuity salesmen?

Let’s face it; annuities raise far too many issues for the 401k fiduciary. It’s one thing for the individual investors to place their hard earned retirement funds in annuities. They take on that risk themselves. Plan fiduciaries that provide employees the opportunity to choose that risk may unnecessarily expose themselves to increased liability. Mr. Wiles was kind enough to provide three of the most prominent reasons why.

1) Higher Costs – Smaller plans have traditionally been the fountain for sellers of annuities. Start-up 401k plans with only a few employees often cannot afford the costs of specialized providers. This represents one of the few scenarios where insurance annuities actually offer a lower cost alternative. Generally, though, once a plan reaches a certain threshold (say, about $3-5 million, depending on the number of employees), annuities become prohibitively costly. And that pertains to the costs the fiduciary can readily identify. The most significant cost concern regarding annuities deals with the difficulty of ascertaining costs in the first place (see the June 24, 2009 Forbes article “Retirement Plans from Hell”). And don’t get me started on the potential of those nagging surrender charges! With Congress demanding more disclosure of fees and the DOL ever fretful of high plan costs, (see the July 2, 2009 Financial Planning article “House Committee Clears Bill on Hidden 401(k) Fees”) the typical 401k fiduciary must enter into any arrangement with annuities with eyes wide open.

2) An Annuity is Already a Tax-Advantaged Investment – Of course, some of those higher costs mentioned above come for a good reason – annuity investors are primarily buying a tax-advantaged investment. As a result, they can afford to give up some performance in exchange for more favorable tax treatment. Think of it this way – many investors are willing to achieve lower yields from municipal bonds versus taxable bonds because they’re saving on taxes. The trouble here is the 401k already offers tax advantages. It’s like offering a municipal bond option in a 401k plan – it’s rarely, if ever, done and only for a very good reason. If the 401k fiduciary offers an annuity option in a 401k plan, how will that fiduciary know the employee understands the implications of using a tax deferred vehicle to invest in a tax advantaged investment? And if the employee doesn’t discover this until years later, is it possible that employee might hold the plan fiduciary liable?

3) Annuities Possess Specific Company Risk – Diversification of individual security risk stands out as one of the primary advantages of investing 401k plans in mutual funds. With annuities, however, no matter if the underlying investments are in diverse securities, the investor ultimately takes on the specific security risk of the insurance company underwriting the annuity. Fiduciaries might remember the liability posed when Executive Life Insurance Company failed in 1991 (see May 20, 1991 Fortune article “Who Got Killed by Executive Life?”). Some say we face similar problems with AIG today. When an investor buys an annuity with the intent of receiving a payment stream for 30 years or so, that investor assumes the risk the insurance will remain in business for that entire time period. After the turmoil in the financial markets last year, and concerns over a repeat in 2010-2011, now might not be the most prudent time to encourage 401k plan participants to move towards those types of companies.

The 401k fiduciary gets bombarded by “innovative” investment options from any number of financial sales people. Worse, as we’ve seen with the 2006 Pension Protection Act and target-date funds, even the government can fall victim to the latest sales pitch. As with any investment, the fiduciary must undertake adequate due diligence to protect the interests of the 401k plan’s beneficiaries. A simple smell test suggests annuities, while they may have their place in start-up 401k plans, may actually increase fiduciary liability.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA


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