To annuitize or not to annuitize -- with apologies to Shakespeare
Question: I am ready to convert my 401(k) into an IRA. I am 61 years old and want to start taking annual distributions. The current balance in the 401(k) is $562,000 and I would like to withdraw 4 percent annually. Fidelity Investments is recommending a Guaranteed Annuity of $400,000 and the remaining in a managed portfolio fund (balanced). The annual fee for annuity is 1.90 percent of the balance and the managed portfolio 1 percent. These are the only fees. There is a 2 percent penalty if withdrawn within the first 5 years. Is this a good option, or should I keep the money in moderate conservative index funds? Emma, Las Cruces, NM
Answer: Your question is among the biggest issues anyone in retirement faces. A generation has been forced to learn about investing in stocks, bonds, and other assets in their 401(k)s, 403(b)s, IRAs and other so-called defined contribution retirement savings plans. It hasn't been easy, and figuring the best way to take the money out is maybe even more difficult. Since you don't know when you'll die, a big risk with a defined contribution retirement savings plan is that you'll outlive the money. Defined contribution plans are really designed for accumulating money rather than distributing it. Without indulging in too much hyperbole, it seems that there is at least a major conference a month about how to simplify the choices for retirees.
Everyone seems to agree that, for most savers, any solution will involve annuities or annuity-like products that combine features of defined contribution plans and the traditional defined benefit pensions. The main advantage of the traditional defined benefit plan is that retirees know how much income they'll receive during retirement and for the rest of their lives. You can't know this with a defined contribution plan like a 401(k), which is why any solution to improving retirement security will probably involve an annuity or something reminiscent of an annuity.
Annuities are contracts offered by insurance companies that pay a stream of monthly payments in exchange for a premium. Alicia Munnell, director of the Center for Retirement Research at Boston College, has a nice post of the basics of annuities and retirement at Smart Money.
I think anyone approaching retirement and in retirement should become familiar with so-called immediate annuities (also known as life annuities and income annuities). I looked at the Fidelity website and it appears the annuity recommendation is an immediate annuity. In essence, you'll invest a sum of money and, in return, get a predictable monthly income (or quarterly or annual income, depending on the chosen payout option) on the investment for the rest of your life. Live until 100? You'll still be getting an income from the annuity. The attraction of this kind of annuity is you can't outlive the income.
So, I can give you some general thoughts. Whether the amount of the annuity is right for you -- or even if you should annuitize -- involves a lot of issues, such as your other assets, savings, income and taxes. That's only the number side of the equation. There are also emotional and psychological issues. For example, my parents annuitized much more than the professionals they consulted advised. They thought about the counsel and they decided to ignore it. They preferred the income security of annuities. They didn't want to deal with fluctuations in the market -- stock or bond. They were comfortable with the trade-offs.
I would spend a lot of time thinking through how much to annuitize. Annuities are inflexible: You don't want to annuitize everything (and that's not the recommendation you've gotten, either). How much to annuitize partly depends on how much additional savings you have on hand to deal with sudden expenses: buying a new car, paying for a new roof, buying an apartment in a continuing care retirement community and so on. Remember, you will have some Social Security like an inflation adjusted annuity, so at least part of your income in retirement is already in annuity form. You can play around with the numbers and put the annuity in a broader financial context by heading to Analyzenow.com. It has several good programs -- as well as insightful articles -- for addressing the trade-offs involved between annuitizing and managing the money on your own (or with the help of a pro).
Another issue for you to think about is today's low interest rates. One way to deal with this is to "ladder" smaller investments in immediate annuities over several years to take advantage of potentially higher interest rates.
Among the most important choices to make if you do decide to buy an annuity is whether to pick the option that adjusts for inflation. It's a menu item I like. Inflation erodes that value of savings over time and, even though inflation is relatively tame right now, it's a big risk all retirees face. The tradeoff: Initial payouts are lower than those from a standard contract. But if inflation flares up sometime over the next few decades, the adjusted payout will rise and more than compensate for lower initial payments.