Susan Conrad, you get a gold star. When asked to comment on the new proposal to include annuity options in a 401(k) plan, Ms. Conrad said, “All annuities are not created equal, and that concerns me. Our industry is moving towards more transparency, and the introduction of annuities as a plan option could take us in the opposite direction.” Anthony Webb, you get a gold star, too. He added, “They’re not offering an inflation-indexed product, but if you are buying a product for 25-years into the future, you are going to be concerned about inflation.”
The argument in favor including annuities in a 401(k) plan, summarized by the St. Louis Post-Dispatch in this article titled “Regulators Seek to Make 401(k) A Bit More Like A Pension”, is this: “Buying a deferred annuity essentially converts a lump sum into a future stream if income. The Treasury rules envision that, beginning at age 55 or later, a target-date fund could start shifting its bond holdings into annuities. In theory, this would give you the best of both the 401(k) and pension worlds. Your target-date fund would still hold some stocks, so you would participate in the market’s future growth, but it would also promise you a steady income beginning at 65 or some later age.”
If you want to make 401(k)’s more like pensions, you should disable the ability of people to sell any of their assets before reaching a certain age. It still wouldn’t mimic pensions because there is nothing to stop you from selling everything after a 30% drop and putting it into a money market fund, but it would be a step in the right direction because it would force you to keep all of your assets inside the wrapper of a 401(k) so that assets could only be depleted by unwise investment choices rather than actual withdrawals.
The reason why I have a problem with adding annuity options to a 401(k) is that such an option is superficially enticing, but would actually result in a significant amount of lost wealth that would become very significant over long stretches of time. To understand why this would be the case, first think about how annuity companies generate a profit in the first place. They receive a lump sum payment from you—say, $100,000 or so—and they promise to perpetually pay you 3% or 4% of the amount that you invest.
What do they do in turn? They take your money, and invest it in large-cap American stocks, often through vehicles that resemble S&P 500 index funds. When they receive your $100,000, they immediately put it into work in Apple, Exxon, Microsoft, Johnson & Johnson, General Electric, Berkshire Hathaway, Wells Fargo, Procter & Gamble, JPMorgan Chase, Chevron, and so on. The 9-10% expected annual returns from that collection of assets creates a large spread between the 3-4% they have to pay you, and explains their core profit-making mechanism (they also frequently charge fees, but one would hope these would be negligible in a 401(k) offering as the bulk size of a retirement plan often enables the negotiated lower fee arrangements).
Over the course of twenty years, the difference in outcomes become substantial. Someone who hands over $100,000 and collects 4% income payouts each year would receive around $120,000 in future benefits on the investment. Someone who help a basket of large-cap American stocks that earned 9.5% would see $560,000 in wealth get created from his lump sum investment. When someone trades in a stock fund that comes close to resembling the S&P 500 for an annuity that yields 4%, they should keep in mind that the annuity’s profit mechanism is to invest the received funds in the same way that the 401(k) investor was doing before making the switch! The amount of wealth foregone over two or three decades from this single decision could prove mind-boggling; you are taking an axe to your and chopping up your future wealth potential by nearly 70%.
Would annuity investments in a 401(k) be 100% destructive? No, I can conceptualize of an investor that would benefit. If you are someone who simply can’t handle stock market fluctuations, then it would be dumb to invest in stocks, as you would certainly sell following a 20% or 30% decline. If bond options only yield 2% or 3%, and you can find an annuity investment that pays out 4%, I could see how an investor with such a temperament could benefit from the existence of such a product.
But for many others, it could be a disaster playing out, when pursuing stability leads to huge amounts of foregone wealth. This is especially bothersome when many 401(k) plans offer a company match of sorts, so your investments could fall 20% or 25% and you’d still breakeven on the amount of capital that you personally have to set aside. It’s crazy what people are sometimes willing to give up in the pursuit of stability. Only 57.2% of American households in the American 55-64 age group own stocks. The number one reason why the amount is so low isn’t because Americans lacked the money to invest (that was reason #2), but because they feared that they would lose money by making an investment.
This fear of loss is why earn mediocre returns by going through something like an annuity—in fact, mediocrity is almost guaranteed when you agree to surrender principal in exchange for a 4% payout. Even if stocks have a more disappointing 25 years ahead, it is incredibly likely that a collection of cash-generating assets featuring Dividend Aristocrats (like Colgate, Nestle, and Exxon) will significantly outperform someone opting for an annuity. And it’s incredibly unlikely they would underperform an annuity. If annuities become options in 401(k)s and become heavily advertised, I shudder at the amount of wealth foregone for the typical American investor that doesn’t know any better.