Annuities for retirement: Good or bad idea?

Jittery investors who are fearful about outliving their savings may have another investment option to consider in their workplace retirement plans. The Treasury Department has issued new guidelines designed to expand the use of annuities inside 401(k) plans. Annuities are attractive to some investors because they offer the ability to build tax-deferred savings, can help to protect the money that you've already saved, and generate a steady stream of income in retirement.

"Life expectancies are getting longer. With that comes an increased risk of outliving one's retirement savings," says Denise Appleby, founder of Atlanta-based Appleby Retirement Consulting. "Annuities can help to prevent that from happening by providing lifetime income for retirees."

An annuity is basically an insurance contract in which you pay a financial institution a specific amount of money—either in a lump sum or a series of payments—and the company then invests your money and promises to pay you a regular income right away or in the future.

With an "immediate" annuity, you can generally start receiving payments in about 30 days. A "deferred" annuity enables you to receive payments at some point down the road. You put in a lump sum or build up funds over time (by contributing a monthly amount) then you convert that amount, or "annuitize" it, into a income stream.

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Despite the benefits, investors need to weigh the pros and cons to make sure annuities are the right option for their retirement portfolio. "If they want more in guaranteed income then an annuity may make sense," said Jeanne Thompson, a vice president at Fidelity Investments, adding that investors should also evaluate how much they want coming in monthly in guaranteed income versus what they want to keep invested.

It's also important to keep in mind that annuities can have varying degrees of risk.

A "fixed" annuity offers a fixed, guaranteed rate of return for a certain number of years.

With a "variable" annuity, the money that you put in is invested and your principal could fluctuate depending on the rise and fall of the underlying investments. That's why some investors purchase variable annuities along with a "living benefit income rider" that will guarantee a certain amount of income. "If you have that income guarantee then your lifetime income would be unaffected even if the account runs out of money," said certified financial planner Mark Cortazzo of MACRO Consulting Group in Parsippany, N.J.

An "indexed" annuity is designed to give an upside from investment returns tied to an index, like the S&P 500. But the indexed annuity also offers protection on the downside since it guarantees a minimum return—though in this low-interest rate environment the return is usually capped at about one to three percent, Cortazzo said.

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While many financial advisors and retirement experts say annuities might be a great options for some investors, they are certainly not appropriate for all.

If you haven't already maxed out your savings contributions in other tax-advantaged plans, 401(k)s and IRAs, it may not make sense to purchase an annuity. But if you're retired or near retirement and you want a guaranteed income stream for a portion of your retirement portfolio, some financial advisors say you should consider buying an annuity. Still, Cortazzo recommends putting no more than 25 to 30 percent of your portfolio into an annuity. "You want to make sure you leave some room for growth," he said.

Annuities have had a bad reputation among individual investors, in part, because of their hefty fees, which can run as much as 3 percent a year or more. Financial advisors suggest that before you buy an annuity, you understand the expenses, management fees and surrender charges that you'll pay if you try to get out of the contract. There also may be fees for additional features like a living benefit income rider.

Participants should also be aware of costs related to their specific 401(k) plan for annuities, said David Kudla, CEO and chief investment strategist at Mainstay Capital Management in Grand Blanc, Mich. "An alternative may be available by simply rolling over your 401(k) to an IRA, where you would have several options for doing this, and potentially less expensive options," he added.

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Yet the Treasury Department's new guidance for annuities in 401(k) plans could help investors allocate their money more effectively, Appleby said. "To the average employee, choosing suitable investments might as well be learning rocket science. As a result, many either do not choose any investments or make blind and uneducated choices. With these annuities as investment options, making suitable choices can be easier."

The Treasury Department explains that "instead of having to devote all of their account balance to annuities, employees can use a portion of their savings to purchase guaranteed income for life while retaining other savings in other investments."

Retirement consultant and best-selling author Ed Slott agrees the Treasury Department's expansion of retirement options to allow annuities in 401(k) plans is "a step in a good direction." Yet, he echoes the concern of several financial advisors that an annuity's monthly lifetime income guarantee may require an employee to invest a large chunk of his other 401(k) balance in order to have a meaningful payout.

"Employees might be better off keeping their 401(k) balances, rolling them over to IRAs upon retirement, and working with their own financial advisors to craft a lifetime income plan (with annuities) that are more customized to their individual needs," he added.