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Do Annuities Make Sense in a 403(b) or 457(b)?
When the 403(b) was first created in 1958 annuities were the only investment option allowed. In 1974 Congress added paragraph 7 to the plan creating the 403(b)(7) custodial account and opening the way for investment in mutual funds. More than 30 years after this act close to 80 percent of all 403(b) money sits in annuity investments. While participation in annuities is not as great in 457(b) plans it still exists. Is it wise to invest 403(b) or 457(b) money in annuity products? |
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| Annuity Background An annuity is contract with an insurance company. Two kinds of annuities exist: fixed and variable. Fixed annuities operate much like a certificate of deposit and come in three basic flavors: traditional fixed, two-tier, and equity-indexed. Variable annuities are simply mutual funds with an insurance wrapper [which includes guaranteed death benefits for heirs and living benefits for participants]. There are two phases to an annuity: the accumulation stage and the distribution stage. What the Industry Says Michael DeGeorge, vice president general council of the National Association for Variable Annuities (NAVA), said in a March 2004 appearance on CNNfn's Your Money program that annuities are right only for people "who have maxed out first in 401(k) and other qualified plans." The 403(b) and 457(b) are other qualified plans. It sounds as though Michael DeGeorge was commenting that individuals should maximize their pre-tax savings opportunities before saving after-tax in nonqualified annuities. Most of us agree with that most of the time. While 403(b) and 457(b) are not classified as other qualified plans, DeGeorge's assertion that you should first maximize your pre-tax savings before considering the purchase of annuities that sit outside of retirement plans makes sense in most cases! Actually, you likely would be well served to consider the purchase of a Roth IRA (regardless of the investment vehicle preferred by the client) after pre-tax savings are maximized. With 403(b) arrangements, the limitation to ONLY annuities or mutual funds will mean that participants have only two choices for the maximizing of pre-tax savings. Those who want the benefits available in annuities should select annuities — those who do not want those benefits should select mutual funds. It would be, as said earlier, inappropriate not to help participants understand the differences so that an intelligent decision can be made. This sentiment is echoed by Gary Schatsky, president of The Objectiveadvice Group, and a a fee-only NAPFA Registered Financial Advisor. He says the truth is that annuities usually only makes sense outside of retirement plans for a very select group of wealthy investors who are in a high tax bracket and are in possession of a significant amount of cash they need to tie up. I don't know Gary or whether he is familiar with the investment limitations of 403(b) arrangements. Additionally, a comment about non-qualified annuities in context of this article appears not to be on point here. Certified financial planner Scott Dauenhauer, president of Meridian Wealth Management says: "Variable annuities make very, very little sense. I think some fixed annuities have a place inside a retirement account. The challenge is finding the right product. That would be one that has a fair rate of interest and a reasonable surrender period or no surrender period at all." My firm belief is that variable annuities make great sense if the participant wants the benefits that a variable annuity can provide and mutual funds make great sense if the participant doesn't want or need the benefits that variable annuities provide. The Knock on Variable Annuities |
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Exceptionally high fees — up to eight times more expensive than mutual funds That depends on what you are comparing. Broad-brush statements really are not of great value. Variable annuities cost something like .80% more (on average) than mutual funds based on studies I have seen. I expect, though, that we can find a high cost variable annuity that is up to eight times more expensive than a low cost mutual fund. I am not advocating exceptionally high fees in variable annuities (whatever that means), however, I am a strong advocate of measuring not just cost but cost versus benefit. |
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Dubious insurance component — in order take advantage of this "benefit" two things must happen: you must die and the market
must have dropped. Even if these two events occur you can protect beneficiaries much more affordably by purchasing low-cost term insurance. If
you die and the market has not declined you are now dead and have paid a hefty fee for a "benefit" that is worthless to your survivors. With term insurance
if you die your heirs benefit whether the market goes up or down. Dubious? Ask the survivors of those 403(b) participants who died during the recent downtown in the stock market, but whose heirs received death benefits much greater than the market value at the time of death. (I field hundreds of calls each month, and am well aware that the death benefits in a variable annuity have been extremely important to the heirs and not just during the most recent downturn in the stock market). And, ask those participants who have peace of mind TODAY, as they look at the death benefit based on previously stepped up market value that is greater than the current account value. These are participants who are not necessarily interested in buying term insurance (and who likely wouldn't do so, especially if they are older when term insurance is pretty expensive) — but who are comforted by the ability to protect the dollars they have saved for their heirs under one umbrella. |
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Surrender charges — often lasting as long as 10 years Surrender charges often lasting as little as 5 years. Surrender charges that are explained to the participant, and tied to the participant's timeline. |
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| Variable annuities, in addition to the death benefit, also provide 1) the ability to have a fixed account
and a variety of equity options from a variety of different fund families in one umbrella with the ability to transfer among those various options,
2) distribution support in the form of guaranteed RMD calculations and payouts; and guaranteed calculations and payouts under the IRC 72(t)
substantially equal payments option, 3) living benefits in the form of guaranteed minimum income benefits, guaranteed minimum withdrawal benefits,
and guaranteed minimum accumulation benefits. This permits participants to participate in equity options while providing protection for themselves.
A recent variable annuity statistical report issued by VARDS, commented about the growing interest of participants in the living benefits mentioned in
item 3: "The recent bear market dramatically heightened interest in protection from downside risk and preservation of principal." Fixed annuities (chosen by a limited number of participants compared to variable annuities) do indeed also provide protection from downside risk and preservation of principal, though they do not include equity options. Mutual funds offer equity options, but generally, no protection from market slides. Thus, variable annuities are important for the participants who want the mentioned benefits as so many do. Those participants are, as they should be, weighing cost vs. the benefit received. Reasons Annuities Are Prevalent in 403(b) Plans The reason that annuities are prevalent in the 403(b) marketplace is that they fill certain needs that mutual funds do not. Additionally, annuities are usually commission-based products that include the personalized service of a representative, and no-load mutual fund offerings do not generally provide that service. Without the one-on-one service, participants must either be 1) self-starters, competent in the rules and regulations of a 403(b) account, who are able to evaluate and choose the investment options without the assistance of a financial advisor, and who are self-motivated to regularly increase their annual contributions, or 2) willing and able to locate a fee-based financial planner who is competent in the rules and regulations of a 403(b) account and pay the fees of that planner. Many, many individuals are not self-starters, and many around the country will not conduct a search for the fee-based planner that understands the 403(b) arrangement well enough to explain it, and whose practice includes helping the individual begin to save what are often very small amounts in pre-tax dollars. |
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Pushed by commission-based sales force The vast majority of the commission-based 403(b) practitioners that I associate with are motivated by what is best for their clients. They evaluate the products and investment options they will offer to their clients based on quality of product/investments and reasonable commission so that they can offer the ongoing personalized service that is so important in the 403(b) marketplace (where most 403(b) programs consist of purely voluntary employee contributions; not employer matching plans as is prevalent in the 401(k) segment, and where the 401(k) model will not work). Keep in mind that many fee-based financial planners either do not have enough knowledge of 403(b) rules and regulations (which can cause problems for both the participant and the employer when those rules are not followed), or their practice does not include helping a lower-income employee start saving a limited amount in pre-tax dollars. We do need both, and I think we are beginning to see more fee-based financial planners becoming knowledgeable about the unique 403(b) rules, then entering this segment. Unfortunately, some of those intend to work only with "high-end" clients with considerable assets, which leaves the brand-new participant or the smaller contributor out in the cold. I hope to see that change. |
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Lack of employee understanding about workings of the 403(b) |
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Lack of employer oversight and understanding about workings of the 403(b) |
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| Low-Fee 403(b) and 457(b) Products Fixed annuities with a fair rate of return and a reasonable surrender charge, and no-load mutual funds from the likes of Fidelity, T. Rowe Price and Vanguard can be attractive low-cost options. Loaded mutual funds can be just as expensive as high-fee variable annuity products. The notable exception to high-cost annuities are annuity products from TIAA-CREF. With fees that are among the lowest in the financial service industry and the absence of surrender charges, a fixed or variable annuity from TIAA-CREF can be just as affordable as a low-cost, no-load mutual fund. The reason that both low-cost providers and traditional commission based providers are needed in the 403(b) environment is so that self-starters can participate with lower costs, and those who need one-on-one help without attempting to locate a competent fee-based planner can participate as well. I have the fondest memories during my years of providing help to my 403(b) clients of those who would never have started their pre-tax savings had I not 1) spent considerable time illustrating affordability and helping find the money so they could begin, and 2) consistently and gently pushing them year after year to increase those contributions. While the commissions were negligible for the small savers, my reward was that I knew I had done a good thing. Cooperation with Employers in Compliance Activities Just recently, I received a call from a superintendent of schools (a member of ASBO for which I authored a Compliance Guide), who had a compliance question, and also, who wanted to touch base on her district's provider approval process. She said two things that I want to share: |
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| 1. | We would like to be able to offer more low/no-cost options to our employees; however, most of those providers
will not agree to take responsibility for honoring the withdrawal restriction rules, reviewing QDROs, handling hardship withdrawal requests, (they want
us to do that), and a few of the other things that the Service Provider Agreement requires. We used the standard service provider agreement from the
NTSAA, which we believe to be very reasonable in its terms. How can we get those providers to cooperate so that we can approve a payroll slot for
them? |
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| 2. | I personally have a variable annuity that includes the ongoing services of a representative, and would not want to
participate with a provider that doesn't include the personalized service. However, some of our employees might not need the motivation that I required —
it is frustrating not be able to offer enough options for those self-starters. |
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| I would suggest that low-cost providers are doing a disservice to the marketplace if they will not
agree to reasonable terms in order to gain payroll slot approval with employers. It makes no sense to simply offer a good investment choice and not be
willing to help employers deal with compliance issues in the areas over which they have control. I would like to see them cooperate in compliance
initiatives because the choices should be there. See: Fees and How They Affect Savings See: Retirement Plan Fees See: 10 Questions to Ask Before Buying a 403(b) Fixed Annuity If You Need Advice Explore hiring a fee-only Certified Financial Planner Practitioner®. You will pay a flat hourly fee and have piece of mind knowing your advisor is not pushing product due to financial incentives. Resource: Protect Your Money: Check Out Brokers and Advisers from the SEC. Annuities in Retirement Immediate annuities or "annuitizing" portions of retirement balances can make a lot of sense in retirement. This involves trading a sum of money for a steady stream of income. Most participants do not want to trade their principle for monthly income — in the public school sector, the state retirement system defined benefit plan(s) provide(s) an income stream — and, in those states where participants and employers contribute to social security, the benefit is also an income stream. Thus, individuals who have saved retirement dollars in a 403(b) account are often more interested in using those values for "discretionary or emergency" lump sum spending needs, and, if not needed, leaving that money to heirs. Immediate annuities (and, the annuitization options available in 403(b) annuity products) need a new face, and some of the providers are beginning to address distribution products that still permit the participant to retain control of principle. That is good — and, once distribution products do speak to the issue of control, then I will agree that "annuitizing" will make more sense than it does now. For more information see: Webannuities.com Annuity Warning Equity-indexed annuities are being heavily pushed by the insurance industry as a way to enjoy the growth of the stock market without the risk. Lack of disclosure and complicated return formulas, coupled with extremely high commissions and long surrender periods have combined to make this "investment" a riddle wrapped in an enigma. Two-tier and bonus annuities are equally suspect. Some agents push the tax-deferred benefits of annuity products. The 403(b) and 457(b) are already tax-deferred vehicles. No further tax benefit is achieved by investing 403(b) and 457(b) money in an annuity. Finally, be wary of those tauting the loan provisions of annuity products. See: The 403(b) Loan: The New Debtors Prison? A few providers do offer Equity Index Annuities, and some 403(b) practitioners include them for a small portion of the 403(b) eligible population (those who simply cannot tolerate risk, but who want to potentially increase interest earnings beyond those offered in a traditional fixed annuity). Many of today's EIA products have been simplified in terms of complexity. I am not opposed to straightforward EIAs for that small segment, and I have seen outstanding results in interest earnings in some of those products. Thus, I wouldn't make a "broad brush" statement that they are bad nor that they are widespread. Obviously, an EIA fills a limited need for certain participants who worry about lack of "20-20 hindsight." Two-tiered annuities are products that should never have happened (and those have been generally chased out of the marketplace with the help of individuals like me). Certain bonus annuity products (that are straightforward and where you are not required to give up your first-born child in order to keep the bonus) may be ok for certain situations. And, I couldn't agree more that loans should not be abused — it is necessary to have them to reassure the participant who might not begin saving in a 403(b) account without assurance that there is a way to access the savings early in an emergency situation — and, that is the only way they should be presented in my opinion. Final Thought The argument that variable annuities "don't make sense," and the implication that annuities are not a good choice in a 403(b) arrangement simply ignores the needs, the wants, and the wishes of many 403(b) participants who would not be able to satisfy those needs in the only other remaining option — mutual funds. It serves little purpose to make broad-brush statements that do not carefully consider the most important person in this picture — the individual participant. |
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Read More What's Wrong With Variable Annuities? by Smart Money |
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