The Friendly Guide to 
Annuities in 401(k) Plans

What is an annuity?

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An annuity is a place to put money for retirement. All annuities can provide guaranteed lifetime income, but they are also a way for people to save for retirement before they start taking income. In fact, most people buy individual annuities to help save and prepare for retirement.

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Ultimately, an annuity is a contract that an insurance company makes promises on—those promises may have to do with growing assets and they may involve immediate or future income payments.

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‍Two ways an annuity guarantees income for life

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‍There are two ways that an annuity can offer an income guarantee: annuitization and the guaranteed lifetime withdrawal benefit (GLWB). The emphasis in both cases is on income that is guaranteed for life, creating a paycheck replacement that the retiree can rely on throughout retirement. Some products increase payments through retirement.

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Annuitization‍

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Annuitization is the exchange of money for regular income payments for the life of one or two people. There are many options for customizing the payments, including the ability to include a death benefit (payment for heirs). Though exceptions exist, only the simpler fixed annuities use annuitization in the 401(k) space.

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Guaranteed Lifetime Withdrawal Benefit (GLWB)

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‍A guaranteed lifetime withdrawal benefit (GLWB): the guarantee that payments will continue after withdrawals deplete the contract or portfolio value. This kind of guarantee allows the flexibility to take larger withdrawals, but doing so reduces or eliminates the income guarantee. The GLWB can be associated with different kinds of annuities and the designs can allow for variations in how the guarantees work.

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We stick to the term “GLWB” throughout our documentation. However, you may see other terms that are often used interchangeably, such as guaranteed minimum withdrawal benefit (GMWB), living benefit, or income benefit.

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‍Explain the different kinds of annuities

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‍There are different kinds of annuities and benefits associated with them. The retail world has more variations in types of annuities than are currently available for in-plan products. The retail products tend to be tailored to provide a high value for a client with certain needs and will do that effectively, but they demand one-on-one planning to fit the right product and configuration for a specific situation.  

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Because of this, the optional GLWBs on retail annuities can have complex rules and may have very rich (high-guarantee) benefits that are also more expensive as a result. The retail and institutional markets are distinct and the in-plan solutions reflect the specific design needs of retirement plans.

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The focus in-plan is simplicity, which often means fewer options. Even when the underlying product structures are administratively complex, the participant experience of lifetime income is fairly simple.

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At a high level, we can divide them into “fixed” and “variable.”

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• Fixed annuities are pooled in the insurance company’s general account and the conditions of the annuities are guaranteed by the insurer. Fixed annuities cannot lose principal.
• Variable annuity assets don’t move into the insurance company’s general account and are subject to the gains and losses of the associated funds.

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Because both accumulation and guaranteed income are important characteristics of annuities, it helps to think along these two dimensions. The following chart gives a high-level summary of the types of in-plan annuities that are being used in solutions today.

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Note: while all annuities can be annuitized for guaranteed income, practically speaking, not all the solutions marketed for 401(k) plans are designed for participants to exercise that option. Even in the retail market, few people annuitize a contract they already own.

Fixed annuity‍

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Fixed annuities pay interest similar to fixed income products like bonds or bank certificates of deposit. A fixed annuity is an insurance product that promises either interest to the contract or guaranteed income (it can promise both).

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Fixed annuities can declare a rate that will be in effect for a period, such as a year. These annuities that have an accumulation value can create guaranteed income either through annuitization or a GLWB.The fixed indexed annuity (FIA) is a kind of fixed annuity that doesn’t declare a rate but does declare a formula that uses an index to determine the interest at the end of the period. The guaranteed income from an FIA comes from a GLWB.

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‍Income annuity

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‍Income annuities are fixed annuities that guarantee income without maintaining an account balance. Instead, the premium goes to income payments, either right away or to start sometime in the future. While there’s no account balance to access, there may still be a death benefit to heirs.

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‍Variable annuity

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‍A variable annuity fluctuates in value based on fund performance, but the in-plan solutions use a GLWB to combine the potential for market gains with income protection. Many of the solutions in 401(k)s use a guarantee structure that doesn’t rely on a variable annuity per se, but the principle is the same.

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The participant’s account balance fluctuates based on market changes while the insurance company guarantees future (or current) income using stated benchmarks, such as the annual value of the account.

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‍Fees!

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‍A fee is a measurable charge for a product or service, but the underlying cost isn’t always assessed as an actual fee. Annuity charges can be either explicit (with a stated fee) or implicit (without a stated fee), but the insurance company is always compensated for the cost of managing the product. The same is true for the cost of guaranteed income.

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• Explicit charges: like mutual funds that charge a fee based on assets.
• Implicit charges: a bank certificate of deposit charges no fee; instead, the customer evaluates different products by comparing the interest rate. 

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Annuities incorporate all of these principles but the specific fees that an annuity does (or doesn’t) charge depend on the structure of the annuity itself and the guarantees.

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‍Annuities: Explicit charges

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‍Annuities can have explicit charges related to the annuity or for additional provisions. The GLWB often has an explicit charge. In the case of fixed annuities, it can have an implicit charge instead.

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Variable annuities have contract charges and fund fees. Solutions that look like a variable annuity may not have those charges because they wrap a GLWB around investments. That means that the insurance company can provide the guarantee by itself, so the only fee is for the GLWB.

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‍Annuities: Implicit charges‍

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Fixed annuities are similar to bank certificates of deposit that estimate and deduct internal costs before offering a rate. Most fixed annuities (including FIAs) don’t assess contract-based fees.

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In the lifetime income section, this guide describes annuity management generally and The Anatomy of a Fixed Indexed Annuity, published by the National Association for Fixed Annuities, provides a more detailed explanation of pricing mechanics for fixed annuities.

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Income annuities purchase guaranteed income, so there are no contract charges. The insurance company its costs are included in the rate.

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‍Guaranteed income charges

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‍A GLWB may have an explicit or implicit charge. The cost of the GLWB can be included as part of other costs but the annuity will offer a lower interest rate. For an FIA, this means an adjustment to the formula that lowers interest rate potential.

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Annuitization has no fee for the participant, but the amount of guaranteed income depends on underlying factors that the insurer considers, especially the expected lifespan of the participant.

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‍How can an annuity be free?

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 An annuity may have no charge, but it is never “free.” The insurance company always calculates a profit that compensates it for selling products that assume risk and reduce uncertainty. This doesn’t mean that explicit charges are better, but they provide obvious transparency. On the other hand, the relationship between annuity premium and the growth rate or guaranteed income is also clear and direct.