Does Your 401(k) Need an Annuity?

If you’re like most workers today, you’re relying heavily on your 401(k) to help fund your retirement.

That could present a problem.

Most workers haven’t saved nearly enough to maintain their quality of life in retirement. A 2008 study by consulting firm Hewitt Associates, for instance, found that less than 20% of employees would be able to meet their needs in retirement.

That’s prompting several firms to introduce a new type of 401(k) plan that combines elements of traditional pensions and 401(k) accounts. Like pensions, they offer a deferred annuity to provide a guaranteed income throughout retirement. (An annuity is a life insurance product that pays income periodically for a specific period of time, or over the annuitant’s lifetime.) As a result, the new 401(k) plans allow you to essentially create a steady paycheck for your retirement, says Jody Strakosch, national director of strategic alliances with insurer Metlife (Stock Quote: MET).

Along with the annuity, these new 401(k) plans contain an investment portfolio. That allows you to take advantage of growth in the stock market.

With these plans, the portion of an individual’s retirement account allocated to the annuity would increase over time, Strakosch notes. If you’re 25, for instance, just 3 to 4% of your retirement account would be invested in the annuity product. By 65, that number probably will have increased to more than 50%, she says. According to Strakosch, combining the two can provide a safe income stream in retirement from the annuity, along with the potential for growth through the investments.

By combining elements of 401(k) plans with elements of traditional pension plans,  you’re exposed to less risk as you get closer to retirement, says Alan Glickstein, senior retirement consultant with Watson Wyatt, an Arlington, Va.-based human resource firm. As a result, Glickstein expects to see these plans become more common, given how current economic downturn has highlighted the risks of today’s 401(k) plans. 

Moreover, by including the annuity within a retirement account, individuals are purchasing the annuity over time, Strakosch notes. Previously, most annuity purchases have been made with a lump sum of money.

Not everyone is sold on the new plans, however. Annuities typically have had higher fees and poorer performance than other investment options, says Steve Vernon, president of Rest of Life Communications, a financial education firm based in Ventura County, Calif. When you’re saving for retirement, your goal should be getting the best performance, he says. What’s more, investors looking for income could simply invest in bonds, which provide interest payments.

On the other hand, an annuity is the only financial vehicle that actually guarantees an income stream, according to Strakosch. 

Vernon also questions the wisdom locking oneself into a contract that may extend for decades. Say you sign up for an annuity at 20-something and live to 80-something. You’re banking on the insurer being around for 60-plus years.  Instead, it makes more sense to shop for annuity when you’re in your 60s, Vernon says. That way, you’ll probably be exposed to the insurer for about 20 years.