The Friendly Guide to 
Annuities in 401(k) Plans

First: retirement income or lifetime income?

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‍You hear the terms retirement income and lifetime income both being used, and there’s a simple difference.

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• Retirement income is a broad term covering both guaranteed and non-guaranteed income sources.
• Lifetime income specifically refers to guaranteed income sources. For the in-plan solutions, this means annuities and solutions that use an annuity. Elsewhere, you may see it used to refer to income that’s intended to last a lifetime but isn’t guaranteed.

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The focus on lifetime income doesn’t mean that someone should expect to rely entirely on guaranteed income sources for retirement income. Most people prefer a combination of both reliable paychecks and withdrawals from non-guaranteed sources.

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‍What’s the difference between “lifetime income” and an annuity?

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‍An annuity is a specific kind of lifetime income. The term “lifetime income” generally refers to anything that guarantees income for life. This includes not just annuities but also Social Security and pensions. Social Security is special because it has an income adjustment for the rise in cost of living. A pension is an employer benefit that is becoming less prevalent in the market. Many companies that traditionally offered pensions have moved away from that system.

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Sometimes, we use the phrase lifetime income when we refer to an annuity because it’s easy to understand on its own. We also use it to avoid the confusion and negative association with the word “annuity,” although the fundamental concept is appealing to most people. Distrust of annuities and insurance companies is understandable because the inner workings of an annuity aren’t obvious. However, insurers manage annuities and figure out the rates using well-established underlying principles.

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‍What about getting hit by a bus?

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‍A common objection to annuities is that you lose your money as soon as you buy it: if I get hit by a bus the next day, the insurance company keeps all my money.

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The “hit by the bus” payment structure is called “life only” and it applies only if someone doesn’t want a death benefit when they decide to use traditional annuitization. Few people prefer this style of payment but the trade-off is that a death benefit (payment to heirs under certain conditions) means that the income payments will be smaller.

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Even though “life only” pays more than an option with a death benefit, the peace of mind of the death benefit may be worth it. The guaranteed payments go down as the death benefit goes up. The difference gets even bigger when the retiree is older when income starts.

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The death benefit compensates heirs if the person receiving income dies before a certain amount of time has passed (10, 15, or 20 years are common periods) or if the payments they’ve already received are less than the premium paid for the annuity. They usually choose by comparing the payments they would receive based on different death benefit options.

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‍GLWB death benefit

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‍For those who are receiving income through a guarantee (GLWB) rather than annuitization, the structure of the GLWB means that the retiree takes income through withdrawals, so the remaining balance passes to heirs. This is similar to the death benefit option with traditional annuitization though there may be special provisions, particularly when it comes to taking withdrawals for required minimum distributions.

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‍Annuitization death benefit

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‍In both cases, the amount of the payment depends on the payments have already taken place. With annuitization, the amount and number of payments that would go to heirs depends on the death benefit option chosen. For example, if a retiree dies five years after payments start and picked a 10-year guarantee, their heirs will receive another five years of payments. With the GLWB, the amount of the death benefit depends entirely on the remaining account value, which typically goes down throughout retirement.

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‍What are the underlying principles for annuity management?

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‍Annuities consider risk in pricing for guaranteed income. The uncertainty of a participant’s lifespan is always one of the considerations no matter how the income is guaranteed (annuitization or GLWB).

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All lifetime income from an annuity relies heavily on actuarial science. In this case, it means the understanding of the factors related to how long different groups of people are likely to live.

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Insurance companies manage risk through the concept of pooling, which allows them to use actuarial science to sell policies to many different people but predict the expected average outcome.

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For example, in the case of term life insurance, they know how long the average person with certain characteristics will live; some will live longer than expected and others will die sooner, but the average tends to stay the same. Life insurance protects the loved ones of those who die sooner; if you live longer than the term, then you didn’t need the insurance.

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An annuity is the opposite of life insurance because people benefit from an annuity when they live longer since the insurer sends a check as long as the person is alive. Some will receive fewer checks because they die earlier than the average and some will receive more because they lived longer, but the insurer doesn’t profit from those who die sooner. Instead, it uses that money to subsidize those who live longer.

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Of course, insurance companies cover their expenses and include a profit margin when they calculate their rates. A significant portion of the profit margin is compensation for the use of capital to back guarantees, since they are required to hold additional money beyond the principal of the annuity. This requirement is part of insurance regulation that assures that the company can make good on its promises.

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‍Considering other risks

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‍Annuities are a very long-term obligation for insurance companies, so they must manage for a range of different future bond rates. On top of this, participants invest in these products over a long period of time. Therefore, product designs have to account for inflows through different market environments.

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GLWBs that include equity risk also have to account for that variability (much of that risk ends up being offset through the purchase of derivatives, which is part of the cost of that kind of guarantee).

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‍What is a general account and how does it work?

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‍The general account is the insurer’s assets that support fixed annuities and guarantees based on fixed and variable guarantees. Because the general account combines assets from many different policyholders into a single pool, it’s able to make a wider range of investments than an individual investor would. Most of that money is in low-risk assets like U.S. Treasurys, but some money may be in higher-risk or low liquidity investments that are expected to have higher returns.

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The amount and types of investments an insurer may hold to back its guarantees are governed by standards and monitored by the state insurance department where the company is based. Rating agencies (A.M. Best, Fitch, Moody’s, S&P) also track the investments and the overall business health of insurers. There are third-party services (i.e. ComDex and ALIRT) that people who sell retail and institutional insurance products use for additional information about the financial security of insurance companies.‍

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Fixed annuity pricing and investment pooling

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‍Even though a fixed annuity has a cash value until annuitization, one individual’s money isn’t segregated from the pool. Fixed annuities and other similar insurance products are also called “spread” products because the insurer estimates what it expects to earn on the money in the pool and calculates a yield by subtracting the spread, which is its costs, including profit.

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In the end, the yield of a fixed annuity includes that spread, or implicit cost, whether that takes the form of interest or the payout rate of lifetime income. One reason it’s impossible to calculate an exact fee is that the insurance company assumes the risk of uncertainty. An investment product can state an exact fee and charge that fee based on how an asset performed over a given period.

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Any time the insurer makes a promise, it’s removing some uncertainty or, in other words, providing a guarantee. This applies to lifetime income, but it also applies to the rate on a fixed annuity. In the case of a rate that the insurer states for a future period, it has to estimate returns from its general account portfolio. While it may have a reasonable idea, particularly when it comes to low-risk investments, there are many unknowns in the market.

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‍How lifetime income fits into the 401(k)

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‍Within a 401(k), all annuities provide the same basic value to participants: income for life. The solutions available today fit into the retirement plan in many different ways. We go into greater detail on the high-level choices the plan sponsor can make in the proprietary framework described in the white paper, “Lifetime Income in 401(k) Plans: A Top-Down Consideration Framework.”