Retirement Safety Comes with Earnings Cap

Buying fixed annuities will avoid market downturns but lock in lower nest-egg gains as well.


You probably know that the White House's middle class task force has proposed a new retirement account. It would be funded with an employee's own money, and designed to produce reliable, if modest, returns -- think Social Security Junior. By providing tax breaks and automatically enrolling employees in the plan, the goal is to attract more participants and place them on a safer retirement track. Now, employees could opt out of the program, and it's always possible they could decide to invest their retirement money in something goofy. But the clear goal, and message, of what the Administration is calling the "voluntary Automatic IRA" is that people will sock these funds away for a long time, let them earn safe returns, and build bigger nest eggs.

[See Best Affordable Places to Retire.] In setting up this proposal, a lot of attention also is being paid to annuities. The reason is obvious -- annuities provide lifetime streams of income, just like Social Security. After 401(k)s tumbled along with the stock market, from late 2007 into early 2009, retirement plans were devastated. Everyone wanted safer and more predictable retirement-plan returns. Who wouldn't? For much of the past year, the retirement-fund industry has been faulted for exposing people to excessive risks. There has been a push, almost a yearning, for safer retirement vehicles, and also for proposals to boost the amount of money that people set aside for their later years.

But while I love Social Security, it has been a lot harder to love annuities. Variable annuities, for example, are often called mutual funds wrapped inside an insurance guarantee. If you put $100,000 in such a product, you can be assured of always receiving back that $100,000, even if the underlying investments you make with your annuity have lost money. But the returns on a variable annuity are linked to the stock market, and thus can carry the same kinds of risks that we've just experienced. Also, many annuity contracts carry relatively high fees and punishing penalties should people want to get out of the contract during its early years.

So, the kind of annuity that presumably would be touted in the voluntary Automatic IRA would be a very plain vanilla product called a fixed annuity. The returns on such a product are set at the outset. The insurance companies doing this work can make that guarantee because they are investing the annuity funds in stable bonds and other interest-rate investments whose future returns are relatively safe and can be accurately predicted.

[See Best Places to Retire.]

Here, however, is where the reality of a fixed annuity may collide with the expectations of people saving for retirement. We want very safe investments. We also want investments with high returns. We can't have both.

So, if you were to set aside part of your salary in a voluntary Automatic IRA, you would need to have that money invested in safe holdings to avoid stock-market risks. Instead of having that money grow by 6-8 percent a year -- which is what stocks historically have done -- you would need to accept returns that might only be half that amount. Then, at the end of your savings cycle, the safe course of action would be to convert that IRA account balance into a fixed annuity that would produce a lifetime stream of income for you. This is a prudent way to build a nest egg. And I'm guessing you wouldn't much like it.

The Insured Retirement Institute, the primary trade group for annuities, did some sample calculation for U.S. News on likely income streams that would be produced by a fixed annuity. The IRI, at our request, made conservative performance assumptions and also assumed this annuity would carry very low fees. In short, this fixed annuity would be a fair deal for retirement savers.

For a 65-year-old man who elected to convert his retirement plan holdings into an annuity, the IRI says, he can receive a monthly annuity payment of $3.90 for each $1,000 in his retirement account. Now, the proposed voluntary Automatic IRA is designed for moderate earners. For this group, amassing $50,000 in savings would require them to set aside 3 percent of their salary for 20 years if they made $50,000 a year. For lower salaries, the percentage would need to be greater, or the savings period would need to be longer than 20 years. But however they amassed that $50,000 nest egg, it would yield monthly payments of less than $200 if they converted their retirement account into a fixed annuity when they turned 65.

Remember, this assumes that the insurance company keeps your plan holdings. If you died after a short time, your estate gets nothing. If you wanted that monthly income to go to your spouse in the event of your death, the plan probably would have such an option. But you'd have to accept a noticeably smaller monthly annuity check. That's because the insurance company is giving up gains by agreeing to continue making payments to your spouse.

Lastly, fixed annuities do not protect us against the impact of inflation. We may be facing serious inflationary pressures because of our rising budget deficits. Seeking the safest basket of retirement investments means protecting yourself from inflation risk as well. Ironically, achieving that goal probably means you will need to hold some investments that may be riskier than you'd like. The alternative is, to be sure, a predictable future you can count on -- a future of guaranteed low returns.

[See 15 Things You Need to Know Now About Annuities.]