Saving is relatively easy. It’s turning a nest egg into a steady stream of income payments that proves difficult. Both individual investors as well as many financial advisors struggle to turn a pool of money into needed income. Running out of funds, sequence of withdrawal risks, and longevity muddle the equation. This is why many advisors and investors have turned to annuities in recent years.
And now, it looks like deriving an income stream in retirement will be easier with the creation of annuities in target date funds and retirement plans.
The question is, should you use them? So far, the verdict is split- with some analysis saying that there might not be any benefit. For investors, looking at both sides could be critical in choosing to use these vehicles in their portfolios.
The Benefits Of Annuities & Retirement
By and large, saving for retirement and goals is easy. You put a set amount into an allocation of assets and you let compounding do its work. The problem for many investors and even some advisors is ‘what happens next’. And that’s turning that pool of money into a steady steady stream of cash to support lifestyles. That’s because of two very big risks- sequence of returns risk and longevity risk.
Longevity risk is the risk that you will outlive your money. Thanks to modern medicine and lifestyles, a retirement portfolio needs to be able to last nearly as long as—and potentially longer than—a person’s working life. The sequence of withdrawal risk has to do with the timing of withdrawals from a retirement portfolio. It turns out that the first few years of retirement are critical to building a lasting nest egg. Start in a downturn and you could run out of money fast.
Annuities have been tapped by investors as they eliminate both of these risks from a portfolio and turn a pool of money into a steady paycheck. Sales of annuities have surged over the last two years- particularly since safe haven bonds have been less than safe with increasing volatility.
The SECURE Act(s) Strengthen
The issue is that the bulk of people’s money lies within their retirement accounts- 401ks, IRAs, etc. Using this money to buy an annuity has long been difficult and comes with many tax headaches. The two SECURE Acts removed several hurdles that prevented annuities from being tucked inside retirement plans. Now, investors can buy annuity options along with their regular mutual fund investments.
BlackRock has taken this one step further.
The asset manager invented the idea of the target-date funds (TDF), which are now commonplace and feature a shifting mix of stocks/bonds as investors get closer to their potential retirement dates, reducing risks. Now, the firm has created a new version of its TDFs- dubbed LifePath Paycheck. Here, a portion of the fund’s assets are invested in annuities with the option of purchasing lifetime income at retirement. The idea is simple and creates a one-step solution to generating income from a portion of a portfolio. Similarly, both TIAA and Capital Group have announced products offering annuities as part of a target-date series.
The end idea is that this takes the guesswork and difficulty of selecting an annuity for a portfolio and embeds it from the onset. Investors can easily plan for future income without having to lift a finger.
Potential Downside
But not all analysts are thrilled that annuities are now making their way into TDFs. And in fact, there could be some major downsides.
According to a new report by Morningstar, TDFs with annuities aren’t a panacea for generating income either. Part of the pitfall comes with construction. Just like regular TDFs, these annuity funds come in different flavors and use different styles of annuities to get the job done. 1
For example, those using income annuities and begin purchasing them during the accumulation phase allow investors to lock in income ahead of time. However, if interest rates are low during this time, investors may lose out on potentially higher income streams. Moreover, this removes a portion of their portfolio’s balance that potentially could be invested elsewhere for a higher return. Conversely, those that use deferred annuities with the option of allowing an investor to purchase income later could provide potentially less income thanks to market volatility. Those that use fixed annuities may not generate enough returns.
Additionally, those locked into income streams thanks to the annuities may not need all the income the TDF generates- such as super savers- and could be subjected to unnecessary taxes.
Morningstar cites a sweet spot of assets for usage. Morningstar also highlighted fees as a potential pitfall for investors. While annuities’ have gotten cheaper, they still aren’t as cheap as index funds. And that could reduce returns and the potential for higher income over the longer haul. Moreover, investors could get slammed on taxes depending
In the end, we still have a long way to go with regards to cracking the retirement income solution. TDFs with annuities do have the ability to help many investors in the so-called sweet spot generate needed income in retirement. However, like all investments, investors really need to check under the hood and kick the tires.
Bottom Line
Annuities remain a great way to generate income in retirement. The new launches of target date funds with embed annuities look to remove a major hurdle from adoption. But like anything, there are some trade-offs. Investors need to really do their research before enrolling in these funds in their 401k or IRAs.
1 Morningstar (April 2024). Target Dates and Annuities … It’s Complicated
