The White House last week strongly endorsed annuities as a needed but missing piece of Americans' retirement plans. Insurance companies and annuity trade groups had something nice to say about Washington regulators for a change. And the new rules just might set in motion some interesting retirement-plan changes.
Among financial products, annuities have long been a very hard sell. It's easy to understand the appeal of buying Apple stock or getting in on the ground floor of Facebook's IPO. Understanding annuities and their benefits, however, is not on the minds of many investors.
The premise of an annuity is easy to state: Give some money to an insurance company and it will make guaranteed payments to you for the rest of your life. The money can be paid now or in the future. The payments can begin at any time the investor chooses. And the lifetime stream of income promised by an annuity can augment Social Security and help put to rest a person's fear that he or she will run out of money before they die.
Insurers have loaded down basic annuities with so many features, fees, and product types, however, that they've hidden the clear premise of the product. No wonder that many investors decide it's not worth their trouble to learn about annuities. That's too bad.
Annuities behave like defined-benefit pension plans. Once they're in place, they produce regular payments that recipients can count on. In fact, when someone gets a defined-benefit pension these days, odds are, their employer's retirement plan will generate the monthly payments by turning the assets set aside for their benefit into an annuity. So, it might be nice to have more retirement annuities in 401(k)s, IRAs, and other retirement programs.
The set of rules announced last week will support more retirement-plan annuities in four ways:
1. They will permit splitting retirement distributions into lump-sum rollovers and annuities. Many employees and even retirement-plan administrators don't think about more flexible choices when cashing out of workplace plans. The new rules encourage so-called "split options" and simplify the calculation of such split benefits, including annuities.
2. They encourage the use of "longevity annuities." This is the name given to an annuity that doesn't begin making payouts until the person typically celebrates their 85th birthday. Because the payments are so far in the future, the current price of such annuities is relatively low (of course, if you die before you turn 85, you might get nothing for your annuity purchase.) Longevity annuities are considered a particularly good tool for women, who outlive men and badly need more lifetime income protection. The new government rules would encourage longevity annuities by relaxing the annual required minimum distribution rules (RMDs) for retirement accounts. RMDs must now be taken from 401(k)s and IRAs when the account holder turns 70½.
3. For employers who have both defined-benefit pensions and defined-contribution 401(k) plans, the new rules would allow employees to use some of their 401(k) assets to buy low-cost annuities in their employer's defined-benefit plan.
4. Current spousal consent rules can block plans from offering longevity annuities and other deferred annuities where income payments begin at a future date. The new rules protect spousal rights to benefits but defer the required consent until the annuity payments actually begin.
Some of last week's changes are already in effect. Others took the form of proposed rules that a Treasury spokesman said would be implemented before the end of this year. These are executive orders and do not require congressional approval through legislation.
Even with new rules, changing retirement-plan offerings and investor behavior will take years. For comparison, a set of important 401(k) changes contained in 2006 pension-reform legislation took several years to take hold. But it has led to huge gains in retirement plan participation. It's also given rise to target date funds—a class of mutual funds designed to automatically adjust their holdings to reflect the retirement investment risks of investors of different age groups.
Another reason retirement annuities will not be taking off as the next big thing is, sadly, that they aren't a very good deal today. To guarantee future annuity payments, insurers usually place annuity purchase funds into very safe investments—bonds or other holdings whose returns are tied to prevailing interest rates.
The Federal Reserve has been keeping interest rates near zero and recently extended its commitment to this policy through the end of 2014. Such low rates reduce the size of guaranteed income payments that insurers can offer to purchasers of traditional retirement annuities.
At the request of U.S. News, the Insured Retired Institute (IRI) calculated a set of current income payments on retirement annuities. The IRI, an annuities trade group, used current interest rates to determine the size of a retiree's guaranteed monthly payments that he or she could get in exchange for the purchase of a $100,000 annuity. The three numbers listed below for each type of annuity are monthly payments to a 65-year-old man, 65-year-old woman, and to a 65 year-old couple. Annuity purchasers commonly choose plans that promise payments for the rest of their life and, should they die, the life of their spouse as well.
Straight Life Annuity: $585, $540, and $496. The income stream is guaranteed to last as long as the annuitant (payee) lives; payments stop when the annuitant dies. A couple may choose a joint life annuity, on which payments stop when the second annuitant dies.
Life Annuity with 10-Year Period Certain: $582, $527, and $490. The income stream is guaranteed to last as long as the annuitant lives, and also guarantees that these payments will continue to the named beneficiary until the 10-year guarantee period has ended. A couple may choose a joint life annuity with period certain, for which the income stream is guaranteed to last as long as at least one of the annuitants lives. Note: Other period terms are available, and there also may be different elections for spousal payments upon the death of the first annuity recipient.
Life Annuity with Installment Refund: $532, $504, and $484. The income stream is guaranteed to last as long as the annuitant(s) lives, and provides that payments will continue in installments until the amount received is equal to the premium paid.
Period Certain Annuity for 10 Years: $915 and $915 (there is no carryover spousal benefit with this annuity.) Payments are guaranteed to continue for 10 years, no matter how long the annuitant lives. If the annuitant dies before the period has expired, payments continue to the designated beneficiaries for the remainder of the period. Note: Other period terms are available.