What are annuities?
Annuities are contracts between you, referred to as the annuitant, and a financial institution, such as a mutual fund or insurance company. In these contracts, you commit to make a lump sum payment or to follow a schedule of periodic payments in exchange for a guaranteed income stream. Under most annuities, you have to hold the annuity until age 59 ½ before receiving any payments.
Annuities fall under three broad types: fixed, variable, and indexed. Each type offers different income potential and is appropriate for a different purpose and reason.
- Guaranteed income, but highly limited set of investment options, if any.
- Immediate fixed annuities require a single and very substantial lump sum payment and start issuing distributions after a short period of time.
- Deferred fixed annuities require several smaller payments over several years and start issuing distributions once you turn age 59 1/2. This type of annuities has a surrender charge to be around 7% of the total investment if the annuity is cashed during the first year. The surrender charge usually decreases by 1% per year until it reaches zero.
- Unlike fixed annuities, variable annuities offer a higher income potential and don’t guarantee income.
- A minimum return on your investment is provided in case of your death (also known as a death benefit).
- Variable annuities tend to have a higher minimum investment requirement than fixed annuities. However, the greater number of options comes at a higher fee, on top of the surrender charge.
- Distributions are indexed to a market benchmark, such as the Dow Jones or the S&P 500. Indexed annuities often offer a minimum return, but it varies among financial institutions.
- The return of an indexed annuity is capped and may be subject to a participation rate (percentage of annuity’s participation in the index’s return) and a spread fee (percentage subtracted from the gain linked to the market benchmark).
- Indexed annuities have just a bit more market exposure than that of fixed annuities but less than that of variable annuities.
3 ways the SECURE Act changes the rules of annuities
Reduced legal liability about annuity from plan administrator
Currently most defined contribution plan sponsors have been reluctant to offer annuities in their plans due to the concern about fiduciary liability if the annuity provider becomes insolvent. Even if the suit is without merit, plan holders are entitled to go to the courts. This may lead to expensive legal fees and a drawn out legal process. Due to this risk, many plans won’t offer annuities, which leaves individuals on their own when trying to add annuities to their nest egg.
The SECURE Act states that “plan fiduciaries, plan sponsors, or other persons will have no liability under ERISA solely by reason of the provision of lifetime income stream.” However, plan administrators still have a fiduciary duty to plan holders (a.k.a. act in the best interest of plan holders).
By protecting administrators from liability for any losses that may result to the participant or beneficiary due to an insurer’s inability in the future to satisfy its financial obligations under the terms of the contract, the SECURE Act eliminates a roadblock to offering annuity options under a 401(k).
Clearer disclosure of annuity income streams
Let’s face it: one challenge with annuities is that they’re hard to understand. While reducing legal liability from plan administrators is a great first step to encourage adoption of annuities, a much needed second one is to help plan holders to better understand annuities.
To address this issue, the SECURE Act requires benefit statements provided to plan participants to include a lifetime income disclosure at least once during any 12-month period. The disclosure would illustrate the monthly payments a plan holder would receive if the total account balance were used to provide lifetime income streams.
Portability of annuities
Under the current rules, a plan participant holding an annuity through a 401(k) would be left in the dust if the annuity were to disappear from the investment options due to a merger, acquisition, or economics. Then, the plan holder has to face earlier-than-expected income taxes and early distribution penalties (if under age 59 1/2).
While the plan holder could try to repurchase the annuity, he or she would now have lost the institutional, lower pricing and would face greater cost in a lower-interest rate scenario.
The SECURE Act now includes a third scenario by turning the disappearance of annuities from a plan into a qualified distribution event and allowing you to plans to make a direct trustee-to-trustee transfer to another employer-sponsored retirement plan or IRA of lifetime income investments or distributions of a lifetime income investment in the form of a qualified plan distribution annuity. This way annuities won’t have to be liquidated and trigger a taxable income event. The change will permit participants to preserve their lifetime income investments and avoid surrender charges and fees.