By Eric Bank, Expert Contributor
With greater reliance on defined contribution plans and individual retirement accounts, Americans are becoming increasingly responsible for their financial decisions, including decisions about retirement.
Specifically, retirees must determine how to withdraw from their retirement accounts without outliving their money.
In its July 2, 2020, report to Congress, the Congressional Research Service offered annuities as an option for converting savings into income.
“Annuities can be used to reduce the likelihood that people may outlive their resources and to alleviate some post-retirement investment risks,” analysts Cheryl R. Cooper and Zhe Li wrote in the report.
Cooper and Li zoned in on four types of annuities.
- Life or immediate annuity: An annuity contract that provides income for life in exchange for an initial lump-sum premium.
- Joint and survivor annuity: An annuity that continues to pay out income to a surviving spouse after the purchaser dies.
- Advanced life deferred annuity: An annuity purchased at retirement with a lower premium. Payments begin at a later age, such as 85.
- Inflation adjusted annuity: An annuity in which the payout amount increases each year. The cost-of-inflation adjustment is financed by a lower initial monthly payout or by a higher premium.
According to the report, annuity options in retirement plans can improve retirees’ outcomes.
The Role of Annuities in Easing Risk
If a retiree withdraws too much money early on in their retirement, they risk depleting their savings too quickly. On the flip side, if a retiree withdraws money too slowly, they risk depriving themselves of necessities.
Annuities can eliminate the uncertainty by guaranteeing a lifetime stream of payments.
“Annuity products provide consumers a set monthly income for life after a particular age, which can mitigate the risk of retirees outliving their money,” according to the report.
Another challenge retirees face is determining how to properly invest the assets that remain in retirement accounts after a lump-sum withdrawal. By using retirement assets to purchase an annuity, a retiree relieves some risks associated with making the right investment decisions after retirement.
Annuity strategies can also be used to postpone Social Security benefits. The longer you wait to claim those benefits, the higher your lifetime income.
Notwithstanding the advantages that annuities offer, their acceptance in the United States lags that of other retirement investments. One reason for lower annuity participation is that until recently, few 401(k) plans allowed participants to convert their plans into annuities upon retirement.
The Secure Act and Annuities
The Setting Every Community Up for Retirement Enhancement Act of 2019, commonly referred to as the Secure Act, makes it easier for 401(k) plans to offer annuities.
The Act requires employers to provide participants in employee retirement plans an annual statement projecting lifetime retirement income. Retirees can use this information when deciding how much money to withdraw from their accounts for purchasing annuities. However, the annual statement provides only an estimate; it doesn’t predict post-retirement investment risks.
In addition, the Act encourages employer-sponsored 401(k)s to include annuities as a retirement option by reducing the employer’s liability if the annuity contract defaults. And it removes the requirement that sponsors choose the lowest-cost 401(k) plan, which frequently eliminated annuities.
Some analysts suggest annuity participation might increase if 401(k)s invested some assets into annuities by default rather than offering annuities as an option. A study published in 2019 in the Journal of Pension Economics and Finance proposes that retirement plan participants would be more likely to choose the annuity option if the plans required annuity decisions 10 years before retirement.
Cooper and Li concluded that investors could make better decisions if they were more financially literate, had access to better information disclosure and received higher-quality investment advice.
About the Author
Eric Bank is a senior financial writer with nearly two decades of experience writing about business, finance, insurance, real estate, investing, annuities and taxes. He served as the Director of Business Analysis for Citadel Investment Group, a Chicago-based hedge fund, for 10 years. He holds two master’s degrees — in Business Administration from New York University and in Finance from DePaul University.