3 Must-Knows Before Investing in Target-Date Funds With Annuities

Key Takeaways

• Target-date funds with annuities are very similar to normal target-date funds. But instead of just investing in stocks and bonds, what they’ll do is start to allocate to an annuity contract earlier on, maybe 10 to 15 years from retirement, and that will give you the option to annuitize a portion of your portfolio at retirement.
• Right now, target-date funds with annuities are only available through 401(k) plans.
• These target dates with annuities provide investors with guaranteed income in retirement. However, additional fees could be a downside.
• A second issue to be aware of when investing in a target date with an annuity is understanding which type of annuity the target-date fund is offering, whether it’s an income annuity or a savings annuity.
• The third issue to consider before investing in a target-date fund with an annuity is recognizing that these aren’t one-size-fits-all retirement-income solutions.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. A new type of target-date fund may be popping up as an option in your 401(k) plan—target-date funds with annuities. Here with me to discuss how these new funds work and how investors can determine whether these funds are a good choice for their particular circumstances is Jason Kephart. Jason is director of multi-asset ratings with Morningstar and co-author of some new research called Target-Date Funds and Annuities ... It’s Complicated.

Hi, Jason. Thanks for being here.

Jason Kephart: Thanks for having me, Susan.

How Do Target-Date Funds With Annuities Work?

Dziubinski: First, walk us through how these new target dates with annuities work.

Kephart: So, very similar to a normal target-date fund, you’ll invest in them hopefully early in your career, save what you can, keep your hands off it, don’t make any sudden moves, let the target date do its work. But instead of just investing in stocks and bonds, what they’ll do is start to allocate to an annuity contract earlier on, maybe 10 to 15 years from retirement, and that will give you the option to annuitize a portion of your portfolio at retirement. So, if you know you want an annuity, these can be a good option for you.

How Can People Invest in Target-Date Funds With Annuities?

Dziubinski: How can people invest in one? Are these strictly available through someone’s 401(k) plan?

Kephart: Right now, they’re only available through 401(k) plans. The products are being launched as collective investment trusts, which are not available outside of 401(k) plans yet. So, it’s really going to be up to your company and your plan sponsors to decide if this is an option for you or not.

What Are the Disadvantages of Target-Date Funds With Annuities?

Dziubinski: Jason, these target dates with annuities provide investors with guaranteed income in retirement, which could be really convenient for an investor who might struggle with going from the situation where he or she is receiving a paycheck versus having to pay themselves in retirement. It’s a very different dynamic. But, of course, there are some downsides to these target dates with annuities. Let’s go through a few of them. The first you say could be fees. How do fees compare for a standard target-date fund versus a target-date fund with an annuity?

Kephart: Well, as the title of the paper says, it’s complicated. So, the tricky thing is there are two types of annuities that are common in these target dates. One is a standard income annuity where you give a lump sum, and you get regular monthly payments. Those annuities don’t really have explicit costs on top of them. There are no extra basis points. It’s more like your checking account. You know your checking account is not free, but the interest payment you get from your bank is not all the interest payment they’re making off your money. So, that makes it hard, I think, to compare one to one because of that opaqueness.

The other ones that are common are savings annuities, kind of like a fixed-index annuity. These do have explicit costs, and they can be around 1%. So, in target dates where fee compression is so strong, and we see a lot of very, let’s call them, opportunistic lawyers who are happy to file lawsuits over fees of 401(k) plans very fast. That I think creates a barrier to adoption, and plan sponsors really have to make sure they understand these and understand that cost and benefit trade-off so they can communicate that to investors who might be scared and saying, “Well, why am I paying 1.1% for this when I could get Vanguard for 8 basis points?”

Implications of Additional Fees of Guaranteed Income Annuities

Dziubinski: In real-world terms, what are the implications over time for those additional fees that these guaranteed income versions would offer?

Kephart: Yes, I think in the scenario with the savings annuities where you can actually see the fee, I think the risk is you’re paying this fee without actually using the benefit. Like perhaps you roll out of your 401(k), and you switch from a target date that has a savings annuity into an IRA where that’s not an option. Well, you were paying that 1% fee, and now you’re not really getting that kind of insurance from it. So, I think that’s kind of a potential drawback. I think if you’re going to invest in these, you really have to commit to really get the full benefit from them.

Target-Date Funds With an Income Annuity

Dziubinski: Got it. Now, a second issue to be aware of when investing in a target date with an annuity is understanding which type of annuity the target-date fund is offering, whether it’s an income annuity or a savings annuity. So, let’s unpack the differences between those two types, starting with target-date funds with an income annuity. How do they work?

Kephart: These are your kind of standard annuities where say you hit retirement, 30% of your portfolio gets carved out, that money gets given to an insurance company, and in exchange you get a contract for a guaranteed set of payments a month. That might be some peace of mind for a lot of people, but those payments are going to be fixed, generally. So, even benign inflation, not like what we’ve been seeing with cocoa prices, but even benign inflation is going to eat away at that over time. That’s kind of a risk. But the benefit is with the rest of your portfolio because you have that kind of guarantee, you can invest a little bit more aggressively and take a little more risk and maybe offset some of that. That’s why just doing a portion of your portfolio really makes sense. That’s kind of how the income annuity works in general. I think that’s the more straightforward of the two.

Target-Date Funds With a Savings Annuity

Dziubinski: All right. Well then, let’s get into the more complicated one, Jason. Let’s talk about how the target dates with savings annuities work.

Kephart: Savings annuity is kind of this catchall for everything that’s a little bit more complicated in the annuity world—fixed index annuities, variable annuities. And the common thing that they all have is these guaranteed lifetime withdrawal benefits. This is the benefit that the person is going to receive based on the high-water mark of your account. So, that’s the nice thing. Even if your high-water mark is at age 63, not 65, the guaranteed withdrawals will be set at that 63 age start. And so, they’ll say like, we guarantee you a 5% withdrawal rate a year. If you do that, even if you run out of money, then the insurance company will start paying the 5%. So, you actually have more control over your balance. The trade-off is you can take more than that, say, 5% out. You say, “Oh, I want to go on vacation this year or I want to go see this pickleball tournament.” So, you take out 10%. But then, the insurance company is probably going to say, “OK, well, going forward, that 5% is now 4%.” And so, it kind of ratchets down. That’s kind of a trade-off. And that’s the one where you actually have that 1% fee on top, too. So, if you’re paying that 1% fee and you never actually run out of money, then that 1% fee—I guess that’s how insurance works, too. It’s better to pay fire insurance and never have to use it. So, I think that’s how the savings annuities work. But I think that one is a little bit more complex because the annuities, like fixed index annuities, they do have some upside potential. So, you can outpace inflation. That’s a benefit. But they’re much harder to understand. They’re not very straightforward.

Which Type Is the Best?

Dziubinski: Does Morningstar think in general that one type is better than another?

Kephart: I think it depends on the person. I think income annuities are a little bit easier to understand. And when we look at the trend in product launches, the more recent trend is one’s launching with income annuities. And I think that might be because they are easier to explain. I think when you’re a plan sponsor at a 401(k) plan, being able to communicate effectively with your participants, the easier that is, the more they’re going to use it, and the more that it works. And I think the real question is five, 10 years from now, even if these things work perfectly as described, if people aren’t participating and opting in, then there’s no reason to use it over a traditional target-date fund.

Target-Date Funds With Annuities Aren’t a One-Size-Fits-All Retirement-Income Solution

Dziubinski: Got it. So, the third issue to consider before investing in a target-date fund with an annuity is recognizing that these really aren’t one-size-fits-all retirement-income solutions. Explain that.

Kephart: Everyone’s circumstances in retirement are going to be different. Everyone’s risk tolerance is going to be different. The more risk-averse you are, the more that having that kind of guaranteed income in your back pocket is probably going to help you sleep a little better at night. But for some people, they might not think that is really a benefit. And the amount to annuitize, some of these are fixed in these target-date funds, some let you choose your own adventure, so to say. Finding out what the right amount to annuitize for you, too, that’s the other hard part. And I think that’s all going to be a personal preference thing that really comes down to risk tolerance and their own circumstances. I think the other thing that’s hard with these target-date funds is they rely on what you have saved in your 401(k) in that target-date fund. So, you have assets outside of that. I think each individual has to take that into account, too.

Dziubinski: Well, thanks for your time today, Jason. I mean, I guess it’s good that now investors are going to perhaps have another option to choose from, and choice is always good, right? So, thanks for your time.

Kephart: Thank you.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch Generating Retirement Income Just Got Easier—or Did It? for more from Jason Kephart.