Do Variable Annuities Belong in a Retirement Plan?

In order to maximize the power of their mortality credits, it's important that these products be illiquid in structure.

Why? Think of an annuity as a long-life income club — when the club is formed, all members pitch in dollars, which will be distributed to whoever is still alive, and those who don't live as long subsidize those who live a long time. If the shorter-lived savers pulled their money out of the club, there wouldn't be enough to pay for the members who reach their 100th birthday.

Still, many savers will need some flexibility.

One possible solution is a guaranteed minimum withdrawal benefit (GMWB). This preserves some access to an equity risk premium, lifetime income protection and mortality credits because the minimum lifestyle guarantee is preserved even after the account balance runs out, along with the flexibility to withdraw assets if an emergency arises or the retiree doesn't live a long time.

While the expected lifetime income will never be as high as a pure variable income annuity, many may find that the trade-offs are worth the cost.

Another method is to blend risky assets with fixed annuities. This allows employees to capture higher returns from equities while benefiting from mortality credits from annuitization.

My recent research with Morningstar's David Blanchett found that fixed annuities should be substituted directly for bonds within a retirement portfolio allocation to benefit from the mortality credits without losing out on stock returns. The retiree can then trade liquidity for mortality credits by deciding when and how much to annuitize.

Additionally, since mortality credits are higher for annuitized income later in life, one can also buy a deferred income annuity (DIA) or a qualified longevity annuity contract (QLAC), which provides tax benefits by shielding up to $135,000 from required minimum withdrawals between age 72 and 85.

Ultimately, retirement planning can be simplified by focusing on the only two possible outcomes: income and legacy. How much does a retiree spend, how much does a retiree pass on after death, how much do they pay in expenses, and how variable are both the income and expenses?

If the goal is to maximize income, the optimal solution is a lean variable annuity. The amount of risk within that VA should be determined by the retiree's willingness to adjust spending so that they can potentially spend more if stocks outperform bonds. Other options may increase expected legacy and liquidity, but any gain in legacy or liquidity will come at the expense of lifestyle.

At the end of the day, there's no question that variable annuities can be complex to navigate. Some are expensive, and there is history of abusive sales practices within the industry. However, the Secure Act gives plan sponsors a clearer avenue than ever before to incorporate low-cost, transparent annuitization products for the benefit of participants.

This has the potential to give savers the clarity and security they need to effectively turn their nest egg into income, and in a world where perhaps the only thing certain is uncertainty, that goes a long way for building a safer retirement.

— Read The Social Security Trust Funds, Explained, on ThinkAdvisor.

Michael Finke, Ph.D., CFP, is a professor of wealth management and Frank M. Engle  Distinguished Chair in Economic Security at The American College of Financial Services.