Reuters just did an article on turning your 401k into a steady stream of income. Annuity companies are now offering what are called "Guaranteed Minimum Withdrawal Annuities," or GMWA's, that guarantee a minimum income for life ... for a price.
The benefit of these plans is that they help investors manage their "longevity" risk, guaranteeing the investor income for life ... if the insurance company lasts that long.
These programs aim to make 401(k)s more like traditional pensions. That's laudable if it helps retirees cope with "longevity risk" - that is, the risk of exhausting savings in a retirement of unpredictable length.
In essence these GMWA's are like perpetuities, or bonds that don't have a fixed maturity date. If you take $100,000, put it in a 5% savings account, you will get $5,000 until you die, and your heirs will get the $100,000 when you pass. These annuities are very similar to that concept.
There are two types of these annuities, variable and fixed. The variable annuities have a variable payout that is tied to some index such as 60% S&P 500 and 40% Barclays Bond Index, whereas the fixed annuities simply provided a fixed return like the saving account example given above.
The industry is pushing two annuity types for the workplace market - fixed and variable. A fixed annuity allows you to purchase a specified amount of guaranteed income for life, with the payments determined by the amount you invest, prevailing interest rates at the time of purchase (higher is better) and when you want to start receiving the income. The payout on a variable annuity can vary, depending on the earnings of the investments within the annuity.
The benefit of these annuities is the guaranteed payout, but that guarantee comes at the cost of a lower payout rate during the retirement period. Like all annuities, there is no free lunch.
The advantage over other annuities is the guarantee: if you die before the assets have been used up, your heirs get what's left. Other annuities, in contrast, require you to surrender control of the invested funds when you start taking payouts, though they tend to offer higher payoffs.
The problem I have with these, and most annuities, are the expenses. Most investors can replicate what is being done in an annuity in their own portfolios or with the assistance of a financial advisor for much less.
GMWBs "can be mind-numbingly complex to understand, and it's difficult to figure out what they really cost," says David Blanchett, head of retirement research at Morningstar. They can be pricey, but those tucked inside 401(k)s benefit from lower institutional pricing. Prudential, for example, says its IncomeFlex GMWB costs $1,500 per year for every $100,000 invested.
"Mind-numbingly" isn't the type of term I would think would be appropriate for an investment for the average investor, especially when it is costing 1.5% per year for basically running a fixed or variable savings account. Take the example offered in the article.
A $100,000 investment in a GMWB might yield annual retirement income of $5,000 for someone retiring at 65...The same investment in a fixed deferred annuity would get the retiree $6,360 in annual income. Or, he could take a bit less initial income ($4,836) but get a 2.5 percent annual inflation adjustment that would spin off $7,900 annually at age 85.
Basically this is the equivalent of putting $100,000 into a savings account that yields about 5% to 6.4%. Ironically, that is close to the 4.45% yield that 20yr A Rated Corporate Bonds yield. Prudential Insurance has an S&P bond rating of A. Typically however investors pay into these annuities 10 years in advance to accumulate the $100,000, so the annuity company is collecting 1.5% per year without paying anything out.
Blanchett worries that putting annuities in 401(k)s could prompt some workers to purchase them prematurely. Because of the annual insurance costs, it only makes sense for older workers within a decade or so of retirement to jump in.
Even insurance sellers caution retirees not to annuitize all of their savings, so there are liquid assets left for large and unexpected expenses.
Locking in a 5% yield in today's environment may seem like a solid return, but these are unusual times, and 5% is below the long-term average of a 10-Year US Treasury Bond. People considering these GMWBs should consider what interest rates are likely to be 5, 10 and even 15 years in the future. One alternative would simply be to start 10 to 20 years in advance and build a ladder bond portfolio to accumulate the $100,000, and then structure it to roll forward, preserving capital and providing the income necessary for retirement.
The Guggenheim Bulletshares would make this a relatively easy task, and instead of paying the insurance company 1.5% or more each year over a decade to accumulate the $100,000, the Bulletshares have an expense ratio of about 0.24% and pay interest appropriate for the bonds portfolio chosen. Once the $100,000 is accumulated after 10 or so years, the money could be invested either in a single longer term Bulletshare or a ladder portfolio. The ladder portfolio of course would expose the portfolio to reinvestment risk, but with interest rates likely to be headed higher in the future that may be a good thing.
In conclusion, people considering purchasing GMWA's in their 401k's may want to consider alternative bond strategies that can accomplish essentially the same thing. A fixed 5% yield today may appear attractive, but on a historical basis that rate is even below average of a 10-year treasury. When and if rates return to normal that 5% yield will likely be substantially below other rates available in the market. A better strategy may be to simply build a laddered or bullet bond portfolio that provides greater flexibility and has lower expenses than a comparable GMWA.
ETFs that may be of relevance to this article are:
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.