What Retirees Misunderstand About Annuities

There was much to like about Wharton School Prof. Olivia S. Mitchell’s Jan. 3 Wall Street Journal article on annuities in 401(k) plans (Should It Be Easier to Buy Annuities in Retirement Plans? Readers Had Doubts).

Mitchell’s reader Q&A followed an earlier article where she suggested annuities as a default option in retirement plans to make it easier for people to turn their retirement savings into retirement income they can’t outlive. Reader responses—unsurprisingly—revealed several aspects of annuities that many retirement savers and 401(k) participants do not fully understand. In the Q&A, Mitchell addressed a number of the most common and persistent misconceptions about annuities, including:

Annuities are Complex

Many readers expressed that annuities are too complex for the average investor to understand and use. In response, Mitchell noted that there are different types of annuities. Some—such as single-premium immediate annuities (SPIAs) and deferred income annuities (DIAs)—are “plain vanilla” products favored by many academic researchers for their income features.

One area where there has been complexity in annuities, Mitchell explained, is in their opaque fee structure, particularly sales commissions, which can make it difficult for consumers to evaluate their true cost and value. She’s right: many traditional annuities are priced with commissions for sales agents and include features designed to drive sales rather than deliver value. But retirement savers should be aware that modern annuities are now available without commissions, with simplified features, lower costs, and often improved benefits, such as higher income payout rates.  

Mitchell might also have noted that new tools now make it easier for consumers to find annuities that convert their savings into guaranteed lifetime income, and to compare existing annuities to low-cost, commission-free products side-by-side. Innovations in annuity design and technology have made it easier than ever for retirement savers to explore, compare, and understand these important products.

The Insurance Carrier Could Fail

Another reader concern related to annuity issuers’ ability to pay claims if the carrier somehow fails. Mitchell addresses this concern by highlighting several key facts:

     • The insurance industry is among the most tightly regulated of any financial        sector.

     • Annuity provider defaults are exceedingly rare—less frequent than bank        failures—and highly rated insurers have “extremely low default probabilities”.

     • Every U.S. state has an insurance guaranty association to help cover        policyholders in the unlikely event an insurer fails, typically covering up to        $250,000 per policy.

For nervous retirees who own more than one annuity, Mitchell recommends a “belt-and-suspenders" approach: diversifying across multiple providers to limit exposure. Before purchasing an annuity, consumers should check the insurance carrier’s ratings to understand the company’s financial strength and ability to pay claims.

Confusion Over Beneficiaries

Some readers suggested that annuities don’t belong in 401(k)s because they can’t be passed on to heirs. Mitchell explains that annuities are designed to prioritize guaranteed lifetime income benefits rather than legacy and that investors who want to leave a legacy for their heirs could do so through life insurance or another investment vehicle.

That is sound advice. The question of what happens to annuity assets when the owner dies reflects a common misconception—that any remaining account value is forfeited to the insurance company. In reality, how death benefits are handled depends on the type of annuity and the payout options selected. Many modern annuity solutions offer optional income riders that provide a guaranteed income stream and allow remaining account value to transfer to a designated beneficiary. Understanding these options is essential when choosing the annuity type and features that best align with your financial goals.

My Investment Portfolio Can Outperform an Annuity

Some readers asked how annuities compare to a laddered portfolio of bonds or remaining invested in the market. Mitchell explains that, unlike bonds or other investments, only annuities provide true longevity protection by guaranteeing income payments for as long as the retiree lives. This is an important difference between annuities and bonds or investments and one that makes annuities an attractive portfolio enhancement for secure retirement income.  

Compared with bonds, Mitchell explains, an annuity is often a more efficient source of income because of mortality credits, which “allow annuities to pay higher monthly benefits per dollar than a self-funded bond ladder.”  In addition, she notes that market investments are used to capture the highest long-term expected returns as part of an accumulation strategy. How much income can be generated from an investments portfolio depends on market performance.

Mitchell could have gone further to point out that overreliance on an investment portfolio for income exposes retirees to significant risks. These include longevity risk, the possibility of outliving savings, and sequence of returns risk —when the market experiences a significant downturn just before or soon after retirement. Sequence of returns risk can cripple the portfolio’s ability to generate sustainable income through retirement.

Annuities are uniquely designed to address these two major risks.

Learn more about how annuities can provide secure income in retirement

Conclusion

There are good reasons why lawmakers are exploring ways to enable easier access to annuity products in retirement plans and why major retirement plan service providers like Vanguard and BlackRock are ramping up their annuity offerings for the 401(k) market—no other financial product is purpose-built to provide retirees with a lifetime of income and peace of mind. That’s the beauty of annuities.

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