Annuities are back (kind of)
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Illustration: Annelise Capossela/Axios
When you retire, you can take your retirement funds, convert them into an annuity, and rest assured that you have a guaranteed income for life. At least in theory. In practice, almost no one ever does this.
Why it matters: One of the biggest problems with the defined-contribution retirement plans most Americans have is that they don't provide an income upon retirement, just a lump sum. At that point, retirees are largely on their own.
- Annuities are the way the market converts a lump sum to an income, but they're generally seen as being opaque and unpopular.
Between the lines: How to save money for retirement is broadly understood. You put aside a little bit of cash each month or each paycheck, invest it in the market, and then eventually, over the decades, it grows into a large sum.
- How to spend money in retirement — and have confidence you're not going to run out — is a much tougher question.
Driving the news: BlackRock officially launched its LifePath Paycheck product on Wednesday.
How it works: A handful of corporate partners, including Adventist HealthCare Retirement Plans and the Tennessee Valley Authority Retirement System, will default new employees into LifePath Paycheck funds, which are replacing traditional target-date funds that move increasingly into bonds as your retirement year approaches.
- The new funds behave identically to existing target-date funds until the employee is 55. At that point, the fixed-income component starts to get switched over to something called "lifetime income," which includes things like forward contracts rather than just plain vanilla bonds.
- The returns on the lifetime income component will be very similar to returns on a normal bond portfolio — but because of the way it's constructed, the new component will be particularly easy to convert to an annuity.
- Once the owner of the fund turns 59½, they have the option — at any point for the rest of their life — to convert the lifetime income funds into an annuity provided by an insurer.
The catch: The annuities won't be indexed to inflation, which means that the guaranteed income will shrink in real terms over time.
- Retirees are also taking on the counterparty risk of the insurers, and need to trust that they won't go bust.
Meanwhile, the insurers are acutely aware of the so-called adverse selection effect: The kind of people who opt for an annuity tend to be precisely the kind of people who have reason to believe they're going to live longer than a dry actuarial table might suggest.
- The amount annuities pay out is therefore conservatively calculated — which is to say, the insurers try to err on the side of paying out less rather than more.
- Because retirees are advised to annuitize only about 30% of their funds, the monthly income can often end up being so small that most people don't think the deal is worth taking.
The big picture: There are more than $3.5 trillion in target-date funds, which are a simple, low-fee way to save for retirement and automatically reduce risk over time.
- By contrast, there is no such thing as a simple, low-fee annuity, at least by index-fund standards.
- While index funds generally charge less than 0.1% in fees, the fees on annuities are generally between 0.5% and 1%, per Morningstar annuity expert Jason Kephart.
The bottom line: Annuities will never be as simple as index funds — but BlackRock's new product does at least move them in that direction.
