American Express established the first pension program in 1875, providing a guaranteed retirement income for workers who had been with the company for 20 years. By the 1960s, roughly half of the private sector workforce was enrolled in a pension plan that provided retirement income without the need to save.
Unfortunately, pension plans have become much less common in recent years — only 13% of private sector workers were enrolled in a pension plan in 2019. The 401(k) plan replaced pension plans as a standard workplace benefit — without guaranteed income — and only half the workforce is enrolled.
The SECURE Act was signed into law in December to increase access to tax-advantaged accounts and prevent older Americans from outliving their assets. In addition to making it easier for small businesses to set up plans, the legislation opens the door to annuities that offer guaranteed retirement income.
Learn about the other notable changes introduced by the SECURE Act here.
401(k) Plan Investment Options
The 401(k) plan replaced pension plans for a variety of reasons. Many pension funds gambled in risky or high-cost investments that hurt performance, while underfunded pensions introduced dangerous liabilities. The 401(k) shifted the risk to employees and eliminated the need to provide retirees with guaranteed income during retirement.
The problem with many 401(k) plans is that financial advisors make assumptions about asset returns. If the market doesn’t live up to these assumptions, investors may not have as much money as they hoped for in retirement. Of course, the market could also outperform and deliver more than expected.
Annuities weren’t included in 401(k) plans for the same liability reason as pension plans — plan sponsors were required to assume the liability. At the same time, 401(k) participants were more apt to take a risk on a higher return generating asset class than invest in the lower, but guaranteed, returns of annuities.
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Encouraging Annuities in Retirement Plans
The SECURE Act encourages plan sponsors to include annuities as an option in the workplace retirement plans by reducing their liability if the insurer cannot meet its financial obligations. In particular, Sections 203 and 204 state that plan fiduciaries, sponsors, or others persons will have no liability under the Employee Retirement Income Security Act (ERISA).
In addition, the SECURE Act requires the disclosure of lifetime income at least once during any 12-month period. The disclosure would state the monthly payments that the participant would receive if the total account balance were used to provide lifetime income streams (e.g., in an annuity).
The result could be plan participants realizing how much guaranteed income they could generate and transitioning assets from stocks and bonds to annuities. While the move could significantly de-risk their retirement income streams, it could also reduce their long-term earning potential.
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Pros and Cons of Annuities
Annuities may seem relatively straightforward on the surface — they provide a guaranteed income for life in exchange for an upfront investment. However, there are many different types of annuities that involve different risks that you should carefully consider before purchasing.
The three types of annuities include:
- Fixed: Fixed annuities provide a guaranteed rate of return over a set number of years.
- Variable: Variable annuities enable you to choose from different options that may have greater earning potential than a fixed annuity, but they may also lose value.
- Indexed: Indexed annuities earn a return based on the performance of a market index, such as the S&P 500, but there are no downside risks and upside limits.
The benefits of an annuity are similar to the benefits of a pension plan. You receive a guaranteed retirement income for life and don’t have to worry about outliving your savings. In effect, it’s a hedge against longevity and market volatility and you don’t have to worry about interest rates.
On the other hand, annuities have significant fees and penalties if you need to withdraw the capital, which means that it’s important to ensure you don’t need it. Income from annuities is also taxed as ordinary income, rather than capital gains, and the insurance company issuing them must remain solvent.
The Bottom Line
The SECURE Act aims to make retirement plans more accessible and prevent older Americans from outliving their assets. One way that it plans to accomplish this is by incentivizing annuities that offer guaranteed income for life. However, there are many pros and cons to consider before investing in them.
If you’re interested in adding annuities to your portfolio, you should discuss the move with a financial advisor to determine the overall impact to your portfolio, including the potential tax implications during retirement and the returns that you could realize after the move.
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