Now that annuities are OK in retirement plans, what strategy is best?

Now that the Treasury Department has blessed having deferred-income annuities in 401(k)s, the next issue to tackle is how best to allocate these annuities within the retirement plan.

Deferred-income annuities, with guaranteed income in the later years of a buyer’s life in exchange for a payment in the present, have been an issue for Treasury this year.

Back in July, the department released rules easing use of these products within a retirement plan in the form of a qualified-longevity-annuity contract. Treasury followed that up with an announcement in late October giving permission to use deferred-income annuities inside of a target date fund.

Regulatory guidance aside, advisers and employers still need to figure out how much workers should allocate toward these annuities, as well as how those annuities might affect the way the rest of the 401(k) is invested.
David Blanchett, head of retirement research at Morningstar Investment Management, covered that issue in a recent paper titled “Allocating to a Deferred Income Annuity in a Defined Contribution Plan.”

“Treasury is acknowledging that annuities can play a vital role for DC participants,” Mr. Blanchett said. “The adviser should be having this conversation [with plan sponsors]: Have you thought about adding annuities to the plan, and if so, in what context? What’s the optimal annuity type, given the participants?”

Morningstar’s analysis of 78,732 scenarios revealed that the average optimal allocation to deferred-income annuities was 30.52% of the investor’s total portfolio at retirement. Four purchase ages were considered: 50, 55, 60 and 65. Mr. Blanchett noted that he didn’t expect to see these annuities purchased more than 15 years prior to retirement.

A series of 10 factors were examined in the analysis, including the current age of the participant, the age at which the income stream will begin, the extent to which the individual is on track to meet retirement savings goals, and glide paths. Life expectancy, mortality and the desire to pass on wealth to heirs also factored into the study.

When DIAs are folded into a target date fund strategy, expect a reassessment of the equity allocation within the portfolio. The block of guaranteed income means target date fund managers can raise their equity allocations. Those changes can, however, affect benchmarking and performance reporting, Mr. Blanchett wrote.

Effective use of DIAs in a retirement plan is going to call for personalized guidance, especially considering how they may affect workers’ Social Security claiming strategies, according to Mr. Blanchett.

“It behooves the person to get guidance through some kind of advice engine to make sure that it’s the right decision for them,” he said. “You need to think about what you’re trying to accomplish in retirement.”

Related Topics: Annuities, Retirement Plans