Does It Make Sense for BlackRock to Add Annuities to Retirement Plans?

In a sign of what could be the future for 401(k) plans and similar defined-contribution retirement plans, BlackRock has begun offering target-date funds with an annuity component. I explain the role annuities can play, what we know so far about the BlackRock LifePath funds and why they could make sense for some workers.

The best place to start is the role of annuities in a retirement portfolio. Economists like annuities because they shift longevity risk from the retiree to an insurance company. Longevity risk is the chance of outliving your savings. Insurance companies can pool longevity risk across a large number of people. We individual investors can’t.

Longevity risk is a key reason why one school of retirement planning thought believes retirees should have all nondiscretionary expenses covered by guaranteed sources of income. Annuities are one such source of this type of income. The two other primary sources are Social Security and pension benefits.

The majority of individual investors don’t like annuities. Annuity contracts transfer wealth from the owner (and their heirs) to the insurance company. They are costly to get out of. Plus, the industry has a bad reputation, largely due to variable and complex annuities. Many sales representatives—oops, I mean “advisers and agents”—pitch high-cost annuity contracts because the commissions are good. All too often they do not understand the very products they are pitching.

This is unfortunate because annuities can be good products when used properly. Plain-vanilla immediate and deferred annuities are designed to simply provide a stream of income as opposed to offering some type of potential growth. Their fees are generally inexpensive as far as annuities go.

Plain-vanilla annuities are appropriate for those who have moderate levels of wealth and are concerned about longevity risk. Such investors typically do not have pensions and/or are otherwise not receiving enough in guaranteed income to cover their living expenses.

If you have more money than you can expect to spend, annuities are not necessary. The same applies if you receive more than enough cash from sources of guaranteed income or have enough income generated from your portfolio that a return to low interest rates and/or a severe bear market won’t hurt you. At the other end, those who have only modest amounts saved probably won’t benefit from annuities either. There just isn’t enough wealth to buy a significant level of income.

Getting back to BlackRock, its LifePath funds act like a traditional target-date fund until the employee reaches age 55. Then BlackRock begins to allocate a portion of the portfolio to “lifetime income,” which is an annuity. Once a 401(k) participant turns 59½, they will have the option to buy annuity contracts from a select group of insurance companies. About 30% of the employee’s LifePath investment at age 65 will be invested in the annuity contract if that option is chosen. The remainder can be invested as the employee sees fit.

Currently, these target-date funds will only be available through certain defined-contribution plans like 401(k)s. Other fund families may introduce similar types of target-date products in the future.

I think annuities can play a role, but they are not right for every person. There are many participants in 401(k) plans who know nothing about withdrawal strategies and likely aren’t familiar with asset allocation strategies. For these individuals, BlackRock’s LifePath funds could make sense. For someone who understands withdrawal strategies and has knowledge about how to allocate, using other mutual funds offered in the 401(k) plan could be a better option.