You may have heard about a recent Treasury Department ruling that allows investors to buy deferred income annuities (DIAs explained below) within 401k plans. DIA plans convert your 401k into a pension.
Up until now you could make IRA contributions to DIAs but with this Treasury ruling target-date funds operating within a 401k or other employer-provided plan will also be able to offer DIAs to participants.
The DIA in effect creates a lifelong pension for retirees as I said. Of course the insurance companies are delighted about this because they are ultimately the ones who provide the income. Trust me, they will urge you to jump on this new “opportunity” every chance they get.
But before you break out the champagne to celebrate this wonder of wonders, let’s take a close look at what these contraptions are, how they work and whether or not they might be a good or bad idea for you.
What Are Deferred Income Annuities?
With deferred income annuities you deposit money into the plan now and get a fixed payment for life starting later on – such as, when you retire. This is exactly how pensions work. In fact, the DIA is indistinguishable from a pension in that respect.
So depending on how much money you contribute to the DIA, you’ll know exactly what your monthly benefit is going to be, when it will begin and how long it will last. The idea is that it will make it easier for plan participants to plan their retirement because it takes the risk out of income planning.
Does It Work?
Generally speaking, I urge you to be very cautious about these bad boys. Here’s why. Income annuities provide income based on prevailing interest rates. And the future income payout is fixed at the time you first sign up.
That means if interest rates are low when you first sign up (like they are now) your payout is going to be ridiculously low when it’s time for you to start getting those checks. So if you are considering a DIA, first have the insurance company tell you exactly what the payout rate is going to be and compare that to your alternatives.
Let’s assume that you figure that over your career, you’ll contribute $14,000 a year for 20 years into your plan. If you use an online calculator, you can see that if the money only grows by 6% on average, your plan value will exceed $500,000 by the time you retire. But let’s be conservative and use $500,000 for comparison sake.
Please review the chart below:
The left side of the chart assumes you go with the deferred income annuity and assumes they offer to pay you $20,000 a year for as long as you live. In reality, the DIA payout could be very different depending on your own circumstances.
The right side of the chart illustrates what happens to your income and account value if you withdraw 4% of the year end account value but continue to earn 6% on average on the account. Again, this is hypothetical even though these growth numbers are conservative. There is no way to guarantee this result. But in this illustration your account value grows and as a result, so does your annual income.
When the numbers are presented this way it’s easy to see that the DIA is DOA and it’s best to tell the insurance company to take a hike. But you have to see the numbers to know. You have to compare.
What About Risk?
It’s true that if you opt for the DIA your income risk is low. As long as the insurance company stays in business, you’ll get your income checks. And if you live a very long time, you might make it work. But what happens if you die the day after you retire? In that case your $500,000 goes bye-bye. Maybe the insurance company will send flowers to the service – but that’s about it.
Also, what about inflation? The fixed income option provided by the DIA doesn’t provide any bump to help you combat rising prices over the years. If you invest your money and earn 6% on average over the years, you’ll have 50% more income in 20 years and that’s going to come in handy.
The deferred income annuity is not a good choice for most people right now. It might work for you depending on your age and financial situation. The later you tap into the account, the higher the payout. But if you remember that retirement income is a very long proposition, you’ll see that it makes sense to consider investing the money for growth and income in a balanced portfolio instead. By the way, that’s exactly what the insurance company is doing with your money anyway.
Do you want to let them keep all that profit on your money? Do you still think the DIA is a good idea? Why or why not?
This assumes that the investor will make 6% every year. Thats above historical averages. In addition, DIAs offer security that a 401k doesn’t because its a defined payout regardless of market conditions.
I don’t support DIAs, but for some people, in some situations, they make sense. In general, I agree w/ your hypothesis.
Neal Frankle, CFP ® says
Thank KJ. You are right that the math requires assumptions – but the 6% is actually below historical average. http://www.investopedia.com/walkthrough/corporate-finance/4/capital-markets/average-returns.aspx
I agree that the DIA does provide some benefits and guarantees – it’s just that they are usually worthless and very expensive. None-the-less, I agree with you; for some people, the sleep at night security is very important. Thanks!