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Guaranteed income can be risky

By Barbara Whelehan ·
Friday, July 2, 2010
Posted: 1 pm ET

Would you like a guaranteed stream of income during retirement? Nearly three out of four Americans (73 percent) say yes, they would like to have a fixed-rate annuity available in their 401(k) plans, according to global research firm Ipsos.

But another survey by Towers Watson shows that when a retirement income guarantee is actually offered in retirement accounts, few Americans show interest. Of companies that currently do offer a lifetime income option, the vast majority (79 percent) say only 5 percent or fewer of their plan participants sign up for these insurance contracts.

What's the problem? My guess is that since they're not automatically enrolled in these products, many employees are paralyzed by inertia. But those who read the fine print may have reservations -- for good reason. They're complicated.

For instance, Great-West Retirement Services, which serves 3.5 million plan participants in the U.S., offers its "Secure Foundation" product, which provides a guaranteed lifetime withdrawal benefit.

The accumulation phase

Here's how it works: In one particular plan, participants can invest in one of five target-date funds or a balanced fund. Ten years before their retirement, plan participants lock in protection from market downturns until they retire. So if the market drops 30 percent, their account remains unscathed. They get to keep all their contributions plus any upside provided by the market for 10 years, minus fees. Fund management fees range from 0.79 percent to 0.84 percent of assets (not bad). Plus there's a guarantee benefit fee that ranges from 0.7 percent to 1.5 percent. These fees may go up at any time.

In this particular plan, the guarantee benefit fee is currently 0.9 percent. That seems like a small price to pay for a guarantee of principal, particularly if we experience a bear market like the one from 2007 to 2009.

So the deal is, your principal is safe for 10 years; you will at least get your contributions, plus any positive market moves minus fees.

The distribution phase

Then, when 10 years is up and you're ready to retire, your assets are converted to an insurance contract, whereupon you're entitled to a percentage of the total assets that you accumulated each year for life. The breakdown is this: You get 4 percent of assets if you're between ages 55 and 64; 5 percent of assets for 65 to 69-year-olds; 6 percent for 70 to 79-year-olds; and 7 percent for those age 80 and above.

In other words, the insurance company keeps the pile of money you accumulated and you get an annual income for life. If your spouse's lifespan is also covered, the payout drops one-half of one percentage point. (So, plan participants between ages 55 and 64 at time of retirement get 3.5 percent instead of 4 percent.)

The prospect of relinquishing the nest egg for annual payouts of those amounts, I believe, is what may stop people in their tracks. While this particular plan lets participants get at principal for emergencies if necessary, that would result in a reduction of benefits.

So let's do a quick analysis. Say you need a monthly income of $3,333 on top of Social Security to maintain your lifestyle. To get a guaranteed income stream for that amount, you'd have to give up an account worth $1,000,000, assuming you retire before age 65. Poof. Gone. No more possibility for growth of your assets going forward. Of course, no worries about a ravaging bear market, either.

Inflation would erode that payment in a few years' time. Plus, consider these uncertainties: What happens if the employer selects a new plan provider or changes plans in midstream? What happens if you get laid off before you reach retirement? Or, what happens if you die after getting three years' worth of payments?

In my view, you are facing risk, whether you sign up for this type of plan or not.

What would you do if you were presented with this opportunity for lifetime income? Please share your thoughts. I'm dying to know what you think!

(Note to readers: Beginning next week I will be sharing this blog space with Jennie Phipps, who has written for Bankrate for many years and is one of the best financial writers I've had the pleasure to work with. I think you will find her blog posts to be insightful and entertaining.)

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Barbara Whelehan
July 12, 2010 at 9:28 am

Hi Richard -- This product that I wrote about is new, not old. But it's not necessarily representative of all the lifetime income options that are available out there. These products are just rolling out, and many are different and therefore difficult to compare. Bankrate will be running a more general article about lifetime income options next Monday, so stay tuned.

Richard Zaehringer
July 12, 2010 at 7:41 am

It's unfortunate that only one type (a very old type)of annuity is presented in this article. The typical retiree will be unwilling to learn more about annuities after reading an article like this one. An author who takes their fiduciary responsibility seriously would perform due diligence and learn about the newer types, more consumer friendly annuities which provide a much higher payout than an immediate annuity, while leaving the balance to the beneficiary.