Should Your 401(k) Be in an Annuity?

^{Source: MyCalculators.com. Table assumes average annual growth of 6%, an inflation rate of 3%, and a drawdown to zero after 30 years. Monthly income is based on annual withdrawals at the beginning of each year.}

Corporate revenue and earnings should keep pace with inflation, so unlike a fixed annuity, we can expect the index fund’s returns to increase annually to account for inflation. (That said, some fixed annuities do offer inflation protection in exchange for receiving lower payments initially). Keep in mind that when annuity rates are low because of a low-interest-rate environment—like what we’ve experienced in the early 2020s—fixed annuity payouts will look especially disadvantageous compared to long-term stock market returns.

Also, keep in mind that your internal rate of return (IRR) from a fixed annuity depends on how long you live. The longer you live, the more valuable the annuity. A 65-year-old man might have a negative IRR in years one through 17, break even after 18 years, and reach an IRR of 4% if he lives to age 95. (That’s calculated with an annual rate of return calculator, with inputs of 30 years, $100,000 initial investment, and $5,832 annual annuity payment, which is 12 times the $486 from the example above.) That’s still a lot lower than 6%.

Another way of looking at the difference between the returns of the annuity and the index fund in our example is that if you withdrew the same amount from the index fund as you would receive from an annuity each month, you would still have a substantial sum left in your index fund if you died in 30 years, but the annuity would become worthless.

Advantages and Disadvantages of Buying an Annuity Within Your 401(k)

All of this means that there are a number of factors on both sides to consider when thinking about whether it makes sense to hold an annuity in your 401(k).

Advantages of Buying an Annuity in Your 401(k)

Sharing his expertise with The Wall Street Journal in April 2019, David Blanchett, head of research for Morningstar Investments, wrote about the advantages of buying an annuity within a 401(k).

Non-gendered pricing. One advantage of buying an annuity within your 401(k)—if you’re female—is that your gender won’t affect the price. Annuity prices reflect life expectancy, and outside of a 401(k), women can expect to pay more (that is, receive a lower monthly payout for the same principal amount) because they live longer on average. On the other hand, bought within a 401(k), this smoothed-out pricing means men might pay more.

Logical choice. People tend to hold most of their net worth in their retirement accounts and in their home equity. And you will always need cash on hand in case of an emergency. You may not have enough non-retirement funds to buy an annuity outside your 401(k). For these reasons, it becomes logical to tap a 401(k) to buy an annuity. It’s also logical to use the money you’ve specifically set aside for retirement, rather than some other pot of savings, to provide a retirement income stream.

Possibility for a higher payout. Annuity payments also might be higher within a 401(k), Blanchett writes, because insurers can save money on marketing when they have a large pool of potential customers supplied by an employer. But you shouldn’t assume that payments are better without seeing what outside annuities have to offer, he cautions.

Disadvantages of Buying an Annuity in Your 401(k)

Slower growth. If you were to buy a deferred annuity, in which you wouldn’t start receiving an income stream until perhaps a decade or more after buying the annuity, your annuity principal would grow over that decade. You could expect to receive an interest rate similar to what a certificate of deposit (CD) would pay, which would be similar to the inflation rate. Therefore, your money will grow more slowly than it might if invested in stocks or exchange-traded funds (ETFs).

Hard to change your mind. Getting money out of an annuity while still in the accumulation phase is complicated and can entail surrender charges. The fewer years you’ve paid into the annuity, the larger the surrender charge may be. Also, once you’ve annuitized, or started receiving payments, your decision is usually irrevocable.

No additional tax benefit. Annuities have the same tax-deferral benefit that 401(k)s have. You don’t pay taxes on the growth in an annuity—or on the money in a 401(k)—until you take the money out. Morningstar’s Blanchett suggested purchasing an annuity using the money in a taxable account if you have the funds. It doesn’t make sense to buy an annuity in an account where you already get the benefit of deferred taxes. However, many people don’t have the funds in a taxable account to buy an annuity.

Failure to at least break even. A concern that people have about buying annuities is dying before they’ve at least broken even with the principal they’ve put into the product. Money that you use to buy an annuity is money that you generally cannot leave to your spouse, children, or other heirs. But you can if you’re willing to pay more to obtain principal protection or period certain benefits, as explained in the earlier example.

Types of Annuities Allowed in 401(k) Plans

A qualified longevity annuity contract (QLAC) is a type of advanced life deferred annuity funded with an investment from a qualified retirement plan, such as a 401(k) or an individual retirement account (IRA). Beginning Jan. 1, 2022, an individual can use up to $145,000 of their retirement savings account to buy a QLAC.

The main benefit of a QLAC is a deferral of taxes that accompany RMDs. The QLAC’s value is not included in RMD calculations. It must begin paying out by age 85. A retiree or near-retiree might wish to buy a QLAC at age 70 before RMDs kick in at age 72 if they have plenty of retirement income from other sources. RMDs used to kick in at age 70½ before the passage of the SECURE Act, but the new age is 72.

The QLAC is not the only type of annuity that you may be able to purchase in your 401(k) plan. You may be able to buy other types, such as a simple fixed immediate annuity (shown in the first table earlier in this article), the far more complicated and expensive variable annuity, and the slightly less complicated and expensive indexed annuity.

The Bottom Line

Few 401(k) plans offer annuities today, and even when they do, workers usually don’t choose them. But there’s a push to expand this option, as the SECURE Act demonstrates. Further, as Boston College’s Center for Retirement Research paper points out, with so many workers now dependent on 401(k) plans, “the question of how they will manage their accumulated assets over their retirement takes on increased urgency.”

Whether to buy an annuity within a 401(k) is a complicated decision that can have a big impact on your retirement. It’s highly personal, and what your co-worker is doing or what your human resources representative thinks sounds good may not be the right choice for you. It’s important to have all the facts and compare your options so you can make the right decision.