New 401(k) annuities can make retirement income a sure thing

If you're like most Americans, you work for an employer that may offer a 401(k) plan or similar type of savings vehicle, but not a traditional pension. This probably means that the size of your retirement income is totally dependent upon how well you do with your savings.

But once you've accumulated a sizable amount of savings and head into retirement, how do you convert that chunk of cash into a monthly pension?

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That's the question the Treasury Department is attempting to answer by implementing new guidelines that allow 401(k) plans to offer annuities as one of their options.

Currently, annuities are sold through many financial institutions, including banks, brokerage firms and financial advisors. In its most basic form, an annuity is simply an agreement between an individual and an insurance company, whereby a person gives up cash today in exchange for a guaranteed income stream tomorrow.

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Many people equate the word "annuity" with a swear word, because there are many annuity products that are total rip-offs. But while annuities are known for having high fees and hefty surrender penalties, they aren't all high-commission, high-fee products.

That's because insurance companies will soon be offering low-cost annuities specifically designed for 401(k) plans. The advantage of these annuities is that they will be comparatively inexpensive because the insurance companies won't have to pay agents a commission.

Whether or not an annuity is a good deal for you depends upon how much monthly income you will receive in exchange for your expenditure of cash.

For example, if a 65-year-old gives up $100,000 of their 401(k) and receives a monthly income of $1,000 in return, that would be an outstanding deal. Conversely, if that same 65-year-old receives just $100 per month in exchange for that same $100,000, that would be a horrible investment.

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So what determines how much income a person will receive? There are several factors, but the largest one—and the one that may have the greatest impact in the near term—is interest rates.

When a person purchases an annuity, whether from a financial institution or through their employer's 401(k), the insurance company takes those dollars, pools the money with other annuity purchasers and invests those dollars in lower-risk investments. Most of the money will be invested in high-grade bonds, loans and mortgages.

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Everyone knows that interest rates are very low right now. For many, they view this period as a great time to borrow money, but not a great time to be a lender.

The fact is that an insurance company has to invest in the same financial markets the rest of us do. Granted, they may—given their size—have access to a few things the average investor doesn't, but by and large, they are stuck with the same interest-rate environment we all are.

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With rates as low as they are right now, the monthly income one will receive in exchange for that lump sum is limited. Again, that's because there's a direct correlation between interest rates and monthly annuity payments.

A second factor that will impact how much annuity income one will receive is life expectancy. Annuity contracts are based upon one's age and are not medically underwritten the way life insurance is.

"When might an annuity make the most sense? When a person wants to be absolutely certain that a portion of their retirement income will continue until their dying day."

This means that the older a person is, the higher the monthly income. This is because, generally speaking, the older that person is, the less time the insurance company is going to be on the hook to have to make those payments.

A recent quote from a simple Internet search illustrated that a 65-year-old male who purchased a single-life annuity for $100,000 would receive $553 per month. This may seem like a high payout, but a single-life annuity will stop payments when the individual dies (just like a pension would cease), and with American male life expectancy now 78 years, that's a pretty good deal for the insurance company.

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There are a variety of options that one can choose besides a single-life option. There is a joint-life option, where the payouts will continue for as long as the two people live. And there are also options that will pay for a specified number of years, options that will pay for a minimum number of years and so on.

So when might an annuity make the most sense? When a person wants to be absolutely certain that a portion of their retirement income will continue until their dying day.

It may take a few years before your 401(k) offers an annuity as an investment option, but keep an eye out for them. With guaranteed income, and the peace of mind that comes with it, they may finally be worth your consideration.

—By Scott Hanson, special to Scott Hanson, a certified financial planner, is a senior partner at Hanson McClain Advisors.