A New Item on the 401(k) Menu

EDITOR'S NOTE: This article was originally published in the October 2007 issue of Kiplinger's Retirement Report. To subscribe, click here.

Like many employers these days, payroll-services provider Paychex does not provide workers with a pension plan. That concerned many employees, who wanted the company to add a 401(k) option that would provide guaranteed lifetime income, says Will Kuchta, vice-president of human resources. "They have other money in stocks and funds, but they also want a stream of income that is above Social Security," Kuchta says.

So six months ago, the Rochester, N.Y.-based company became one of a growing number of employers to add an annuity to its 401(k) menu of mutual fund choices. Paychex chose a product from Genworth Financial, which, along with Metropolitan Life Insurance Co. and The Hartford Financial Services Group, has designed new annuities specifically for 401(k) plans.

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To capture the potentially huge 401(k) market, insurers are changing their pitch. For years, they've argued that annuities were a great way to enjoy the buildup of tax-deferred income. Meanwhile, we've warned investors not to buy annuities for their 401(k)s or IRAs, which already provide a tax deferral.

But as traditional pensions become a workplace rarity, insurers are focusing on employees' desire for lifetime income guarantees. Here's the new pitch: Say you invest $100 a month in MetLife's Personal Pension Builder annuity within your 401(k) starting at age 50, and then increase your contributions by 3% every year. Your 15 years of monthly investments will buy you a guaranteed annual payout of $2,269 for the rest of your life starting at age 65 -- assuming interest rates don't change a bit between now and then.

Low Returns and Little Flexibility

Christopher Cordaro, chief investment officer with Regent Atlantic Capital, in Chatham, N.J., says the idea is appealing in theory. But 401(k) annuities, as they're structured now, may not offer the best way to invest for retirement. In return for lifetime income guarantees, you may be giving up flexibility and the potential for greater investment growth -- and the chance for higher guaranteed income in retirement.

Cordaro ran the numbers for the MetLife example and found that -- at today's low interest rates -- the payouts would amount to just a 4.4% annual return if you lived until age 85 and 5.1% if you lived until age 90.

Instead, you can get lifetime income by investing in a diversified portfolio of mutual funds and, at retirement, using some of your 401(k) savings to buy an immediate annuity to provide lifetime payouts.

Of course, you'd be taking the chance that interest rates could be low when you bought the immediate annuity -- and that the low rates could more than offset the higher expected returns from a diversified portfolio.

But it's also possible that rates when you reach retirement will be higher, magnifying the power of higher returns. Proponents of the annuity note that by buying a little bit of guaranteed income each payday with a 401(k) annuity, you'd be hedging your bets by investing in all rate environments.

A big disadvantage, though, is that your money is not available to you as it would be with a diversified portfolio. A worker who switches jobs might be blocked from making future annuity contributions. Also, if you need money for an emergency before the lifetime income stream begins, you could lose big time. Each insurer uses its own complex formula to convert the lifetime income stream to a lump sum -- at a cost to you. Still, for many the guarantee of lifetime income has powerful appeal. If you're interested, study your employer's option carefully.

To maintain liquidity, don't invest too much of your 401(k) in an annuity. Most of the Paychex employees who invested in the annuity have limited their investments to 10% to 20% of their total contributions. Consider this as part of your fixed-income portfolio when investing the rest of your 401(k) money.