401(k) plans were originally designed to help participants build a sizeable nest egg that would provide supplemental income to help them live comfortably during retirement.
But, in recent years, many participants have expressed concerns that their retirement savings will run out before they pass on, especially if they live well into their 90s or need long-term care.
Thus, there’s been a lot of discussion of so-called “lifetime income” solutions that make ongoing payments to retirees for as long as they live and, in some cases, to their surviving spouses after they’ve passed on.
How are they different than regular 401(k) investment options?
Most 401(k) plan assets are invested in mutual funds that are designed either to generate income or increase in value over time until withdrawn.
Two of the largest risks to the success of an income strategy based on withdrawals from your 401(k) account are the timing of these withdrawals and future tax rates.
Economic and market factors can increase or erode the value of the mutual funds in your account. If you need to start taking withdrawals during an extended bear market, this could potentially impact the future growth of your account.
Lifetime income options, on the other hand, aren’t impacted by market conditions. Once you purchase the option, you’re supposedly guaranteed a stream of monthly or quarterly payments for life.
During retirement, the combination of periodic income payments and Social Security checks might provide a dependable, predictable stream of income that may cover a meaningful portion of your living expenses. This may make it less necessary for you to have to take outsized taxable distributions from the remaining assets in your 401(k) account.
Lifetime income options are very controversial. While they may be appropriate for some retirees, there may be other ways to achieve this same objective, which is why it may be worth discussing your retirement income objectives with an independent financial advisor.
Do participants want lifetime income solutions?
If you believe the many surveys conducted mainly by companies that offer them, the answer is “yes.” For example, according to one study conducted by Nuveen, 70% of plan participants would prefer to work for a company that offered lifetime income solutions, and 50% of plan sponsors were thinking about adding these options to their plans.
Which options are available?
Generally, most lifetime income solutions used in 401(k) plans fall into two categories: annuities and target date funds (TDFs) with lifetime income provisions (also called “hybrid annuity TDFs”). Let’s take a closer look at both.
Annuities
There are many categories of annuities, but their general purpose in 401(k) plans is to provide income for life starting at a certain date. For example, at retirement, you could use $100,000 of your $1,000,000 401(k) nest egg to buy an immediate fixed income annuity that might pay you $550 per month for the rest of your life and the life of your surviving spouse. This amount may increase each year to offset the impact of inflation.
The monthly payments count as taxable distributions from your 401(k) accounts. However, these payments can be used to offset the amount you need to take as Required Minimum Distributions (RMDs).
Annuities charge significant fees that are usually much higher than those charged by mutual funds. Also, it may be difficult or impossible for you to withdraw principal from the annuity if you need it for an emergency, and if you can take money out you may pay significant penalties.
Hybrid annuity target date funds
Target date funds (TDF) gradually shift assets from stock funds to bond funds as the investor’s projected retirement approaches.
Hybrid annuity TDFs begin to invest some of their assets into an annuity anywhere from 10 to 15 years before the target date. At a certain point, usually at retirement, you can start receiving regular income payments from the annuity portion that will last your lifetime (some of these TDFs allow you to start taking payments at a later date).
Annuity payments made from TDFs held in your 401(k) also count as taxable distributions. One issue to consider: Overall expenses for hybrid annuity TDFs are generally higher than those of regular TDFs, due to the embedded costs of the annuity.
When will plans start offering lifetime income options?
The SECURE Act of 2019 removed some of the liability risks that had discouraged plan sponsors from offering lifetime income options. However, at the moment, it’s estimated that less than 10% of 401(k) plans offer them.
Why? Because these options are complex and difficult to understand. This creates an issue because plan sponsors are legally required to thoroughly vet lifetime income options with the same level of scrutiny they apply to evaluating mutual fund options.
There currently aren’t any third-party tools that empower plan sponsors to conduct this due diligence. Plan sponsors who want to make these options available may need to work with outside consultants to determine which are most appropriate for employees at various stages of life and whether their fees are reasonable.
An alternative
If you’d prefer not to wait until lifetime options are available in your plan, it may be possible for you to take an in-service withdrawal from your 401(k) plan account and roll that money over into a brokerage IRA that can invest in annuities or an annuity-only IRA offered by insurance companies. If you’re over age 59½, you won’t pay an early withdrawal penalty or taxes on these withdrawals.
However, before you do that or choose any lifetime income options available in your plan, it is important to consider how these options relate to your overall financial plan and retirement income strategy. Consulting a financial advisor can help you determine if these options are appropriate, weigh the specific pros and cons based on your income needs, and give you the opportunity to discuss possible alternatives.
This article was authored by Michael Flaherty and Jeffrey Briskin. Michael is a senior financial advisor with Canby Financial Advisors, a SEC-registered investment adviser. SEC registration does not constitute an endorsement by the SEC nor a statement about any skill or training. Michael can be reached at 508.598.1082 or mflaherty@canbyfinancial.com. Jeffrey Briskin is Director of Marketing at Canby Financial Advisors.
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