Thursday, February 12, 2009

Waiter, there's an annuity in my 401(k)

Guaranteed income during your retirement. That would certainly set your mind at ease. How do you get a guaranteed income? Social Security? Ummm, errr. A company pension? Sadly, those are a relic of the time of Don Draper. A relatively new and untested option, 'hybrid 401(k)s', may be able to provide the guaranteed income you're looking for.

A dozen or so asset managers and insurers, including AllianceBernstein, AXA, Barclays Global Investors, John Hancock, MetLife, and Prudential, are designing a new breed of retirement instrument that combines elements of pensions and 401(k)s. These products—call them hybrid 401(k)s—have begun slowly rolling out. And while they differ in structure, all combine annuities—essentially, insurance contracts that provide periodic income payments—with an investment portfolio. The hybrids won't protect investors from violent market swings. But they'll guarantee a certain amount of monthly income for the rest of your life.


The structure BGI's finance wonks came up with embeds fixed deferred-income annuities (which provide a set amount of monthly income in retirement) into a target-date fund. A 401(k) participant who chooses SponsorMatch—or whose employer uses it for the matching contributions—would have part of each contributed dollar invested in the annuities and part in the investment portfolio. Essentially, the annuities replace the bonds that would normally be in your portfolio (emphasis mine). If you're in your twenties or thirties, you'd have only a small portion in annuities; but as you age, that portion increases. As with a regular target-date fund, BGI would make those changes for you. Your investment portfolio, comprised of index-based investments, would also be automatically managed for you based on your age. You would simply pick SponsorMatch and sit back. When you received your 401(k) statement, you'd see two pieces: the amount of monthly income you'd have in retirement and the value of your investment portfolio.
Why do we need yet another asset type to put in a 401(k)? A BGI executive makes the argument that 401(k)s weren't meant to be the primary way of saving for retirement. 401(k) investors have historically underperformed institutional investors by 2% a year. There is also the problem of outliving your retirement money. These hybrid 401(k)s promise guaranteed lifetime income (for a price), and are designed to be more like pensions than traditional 401(k)s.

What's wrong with plain old target-date funds?

You might think that current target-date funds would be set up to provide lifetime income, obviating the need for an annuity in the fund. As it turns out, even those funds with the closest target date suffered bad losses in the recent market downturn, impairing their ability to provide income. The reason for this impairment was a heavy stock allocation in those target-date funds.
Fidelity Freedom 2010, which is down 21% year to date, had about 49% of its assets in stocks as of Aug. 31 (these are 2008 dates), according to Morningstar. Vanguard Target Retirement 2010, down 19% this year, had 54% in stocks as of June 30. T. Rowe Price Retirement 2010, down 23% year to date, had about 59% in stocks at June 30.
In fairness, and as one of the fund representatives mentions in the linked story, some of these funds are planning for people with 40 year retirements, which would require a heavier allocation of stocks than bonds in order to make the money last that long. But at first glance I would have expected a 2010 target-date fund to have a much higher bond allocation.

Can we become annuity fans?

Given the fact that the target-date funds hold a high allocation of equities, and the risk of the markets tanking like they've done over the last year, annuities may be a workable solution to the lifetime income problem. Now, I'll come right out and say that I have a bias against annuities. One of the articles addresses this directly:
Academic research has long shown that retirees need monthly income and that annuities make sense in theory, but people don't like them—often for good reason. Many retail annuities sold to retirees are too complicated, too expensive, and too restrictive.
The annuities in the hybrid 401(k) mostly avoid these issues. The fees are only 50 basis points, and there are no fees to cash out. But I have seen nothing about how the hybrid 501(k) will mitigate the insolvency risk of the insurer that is issuing the annuity. In these times, I worry about insurers going belly up and being unable to pay an income stream. Regular 401(k) funds hold stocks and bonds. Short of massive fraud, even if your fund company goes belly up, the stocks and bonds in the fund should still be there. When an insurance company goes belly up, I worry that there might not be anything there with which to pay your annuity.

Enter your state's life and health insurance guaranty association. Each state has a guaranty association that will backstop insolvent insurance companies. There is a Web site,, with information about state guaranty associations. For example, in my state of New York, the Life Insurance Company Guaranty Corporation of New York, will only protect up to $500,000 of annuity contracts. I would like to hear more about how the annuities in the hybrid 401(k)s would be insured.

Finally, and off on a bit of a tangent, contrast the insurance guaranty association's annuity protection with that offered by the Pension Benefit Guaranty Corporation (PBGC), which guarantees failed company pension plans. In 2009, the maximum monthly guaranty (with no survivor benefits) for a 65 year old is $4,500. The PBGC monthly guarantee equates to a return of over 10% a year on $500,000, and it's risk free since it's guaranteed by the PBGC.