Deloitte’s annual survey of the current top priorities for 401k plan sponsors (“New Survey Reveals How 401k Plan Sponsors Rank 8 Hot Topics,” FiduciaryNews.com, December 20, 2011) produced this shocker: annuities aren’t as popular as the 
press, the government, the academic world and the insurance industry make them out to be. This apparent lack of cupidity has perplexed many, leading even the gurus of behavioral finance – Shlomo Benartzi and Richard Thaler – to co-author with Alessandro Previtero a paper in the Journal of Economic Perspectives on the “Annuity Puzzle.”
To help solve this puzzle, the IRS announced on February 3, 2012 new policies regarding annuities in 401k plans. These fixed annuities, called “Longevity Annuities,” would be similar to bonds in that they would pay out a fixed income over the life of the beneficiary. Unlike a bond, when the beneficiary dies, there is no testamentary pay-out. In its announcement, the IRS indicated this new policies was consistent with its goal of reducing income uncertainty during the retirement years. Indeed, not only is the IRS allowing annuities in retirement plans, the agency is even promoting their use by allowing investors to defer required minimum distributions (RMD) until they’re 85 – more than a dozen years after the current RMD age.
Its press conference, however, left reporters with unanswered questions. And when reporters leave with unanswered questions, they turn to industry pros to get a better view of the issue.
Companies began to shy away from pensions because they wanted to remove the structural liability inherent with defined benefit plans. Unlike what some in the media have called for, the new IRS policy doesn’t reverse this trend. “I don’t think the announcement changes the lack of desire companies have for establishing and maintaining pension plans,” says Amy Jo Lauber, CFP®, President of Lauber Financial Planning in West Seneca, New York. “There has been a general trend towards each person being responsible for his/her own retirement savings for the last 15-20 years. This is just another option for people to do that.”
While many feel the more options the better, Michael Stillman, Senior Vice President at International Research & Asset Management, Inc. in Dallas, Texas brings up a different concern. He’s worried the IRS may have created a fiduciary loophole that could put investors at risk. “The IRS is allowing plan sponsors to provide investment education on annuity products without it being considered investment advice,” say Stillman. “This allows plan sponsors to dodge fiduciary liability to some extent (but they still need to document how the annuity provider was selected). If plan sponsors don’t offer plan participants fiduciary advice, many will underestimate the financial risks.”
This is where the IRS proposal differs most from pension plans, where the liability for paying the income stream to the retiree falls on the sponsoring company. “The new proposal is to let account owners (i.e., participants in a defined contribution plan) to buy an annuity with their balance,” says Paul Escobar of Somerset Financial Partners in Boston, Massachusetts. He adds, “The investment risk would be borne first by the participant and second by the insurance company.”
How much of a risk? A spokesman for the Insured Retirement Institute (IRI), which has been called the “primary trade association for annuities” by U.S. News and World Report, told FiduciaryNews.com “During the financial crisis and recent recession, not one insurer ever missed a payment.” He further explains, “State guaranty associations are offered in every state to protect contract owners against the insolvency of an insurance company that has issued certain insurance contracts, including annuity contracts. Guaranty associations are funded by the insurance industry, not taxpayers.”
While Escobar confirms “insurers typically don’t go bankrupt,” he points out “even in the spectacular cases of Executive Benefit, Mutual Life and even recently AIG – the annuitants didn’t lose their money. Payments may have been delayed (in the case of ExecBenefit) while they straightened out the reorganization. The worst case would be more akin to the UK, where fixed-annuity like products had their credit rate cut to zero.”
Stillman, perhaps speaking for millions of suspicious Americans, remains weary. Despite these supposed safeguards, he remains concerned the downside risk may be too high for some to stomach. After all, if the 2008 credit crisis taught us anything, it’s that nothing is guaranteed. “Perhaps the most material risk in offering the annuity option is the credit risk forced on the American worker,” he says. “If the insurance carrier goes under, the employee’s entire annuity income stream is lost. Plan sponsors need to be cautious before making an annuity option a part of their plan.”
Lost among this discussion though, lies the most fundamental reason why annuities may not be popular among the bulk of 401k participants. Indeed, even Bernartzi et al (in the paper reference above) admit for “the sizable portion of households… there is not an annuity puzzle… there is a savings puzzle.” Lauber agrees. She’s seen “very few people annuitize their retirement.”
Escobar is more passionate about the lack of savings. “This has been my main point for these last several years,” he says. “Most defined contribution participants don’t have enough saved to make annuitizing worthwhile. That is, by most estimates, the average worker has approximately $50,000 saved. At a 5% Guaranteed withdrawal rate, this is a paltry $2,500 per year.” He questions the value of providing annuities in 401k plans, even if participants have sizable balances. For them, he says “it would seem that the right thing to do would be to roll their balance out of the plan and shop for annuities in the open market. There are advantages to buying several annuities from different carriers, to spread risks, benefits, and features.”
In this case, Stillman agrees with Escobar. He says, “few middle income employees will find annuities a good fit because the size of the investment needed to generate a meaningful annuity income will require too much from their retirement nest egg. Annuities should not be the cornerstone of a person’s retirement strategy. Annuities are a complementary position in a larger investment portfolio.”
Even the IRI spokesman concedes “an annuity—on its own—should not be the lone source of income in retirement.” The spokesman did, however, stress “lifetime income options can provide greater certainty in retirement and minimize the risk of retirees outliving their retirement savings. An investor interested in learning more about generating lifetime income through an annuity as part of his or her retirement savings plan should have a conversation with a financial professional, who can help the investor develop a retirement plan based on various sources of retirement income. He or she can also help the investor determine how much lifetime income can be generated with an individual’s retirement savings and what an appropriate level is for that investor’s retirement situation.”
Both Lauber and Escobar would have no problem placing clients into annuities, although with certain caveats. “This is a highly individualized answer,” says Lauber. “every client has a different fact set in terms of assets, liabilities, tax situation, longevity, marriage, children, insurability, estate wishes, goals, income needs etc…” Still, she says of the possibility of using annuities, “I don’t rule anything out.”
Similarly, Escobar says that although he recommends annuities, “for individual clients based on their individual circumstances, I will not be recommending that 401k or other defined contribution plans add annuity features.” He won’t because he feels this will “add an entirely new layer of complexity and fiduciary oversight to the sponsor.” For Escobar, “it’s not clear to me that the institutional products which are just coming out are ‘better’ than what’s available retail.”
Stillman describes the situation this way: “The insurance lobby is perhaps the most powerful in Washington. If these products were not immensely profitable for the companies who offer them we would not be having this discussion. On the other hand, having more options is a good thing and over time perhaps the market place will push down annuity costs and help them become a viable option.” Until that happens, his firm doesn’t plan to recommend the annuity option “because the risk-reward for retirees is far too low.”
In the end, concludes Stillman, the IRS announcement “is not the win for Main Street that many might think.”
