Regulators seek to make 401(k) more like a pension

The 401(k) has become America’s main retirement savings vehicle, but it has a couple of big flaws.

Unpredictable markets can put a big dent in the standard of living of a retiree or near-retiree, and even the most diligent saver runs the risk of outliving his or her nest egg. Neither of those pitfalls could happen to beneficiaries of oldfashioned defined-benefit pensions, which have almost vanished in the private sector.

Now, rule makers in Washington want to make the 401(k) look a bit more like the old-fashioned pension. They think retirement plans could be improved by adding something called a deferred income annuity.

The Treasury Department and the Internal Revenue Service recently issued guidelines allowing these annuities to be part of a target-date fund inside a 401(k). Employers often make target-date funds the default investment option, so the rules could eventually lead to widespread use of annuities.

Buying a deferred annuity essentially converts a lump sum into a future stream of income. The Treasury rules envision that, beginning at age 55 or later, a target-date fund could start shifting its bond holdings into annuities.

In theory, this would give you the best of both the 401(k) and pension worlds. Your target-date fund would still hold some stocks, but it would also promise a steady income beginning at 65 or some later age.

The new guidelines are the second regulatory move this year to encourage more use of annuities inside 401(k) plans. This summer, the Treasury and IRS issued rules allowing investments in longevity annuities, which begin payments at an advanced age.

For some people, these new tools will indeed make the 401(k) better. An annuity inside your target-date fund could provide some guaranteed income as soon as you retire, or a longevity annuity that kicks in at 80 or 85 could ensure that you don’t outlive your savings.

These investment options aren’t available yet, and some important questions still need to be answered.

Anthony Webb, an economist at Boston College’s Center for Retirement Research, is an advocate of longevity annuities, but he wishes they would come with inflation protection.

“They’re not offering an inflation-indexed product, but if you are buying a product for 25-plus years in the future, you are going to be concerned about inflation,” he says.

Another issue is cost. Any retiree could convert part of his or her 401(k) balance into an annuity today, but few do. That’s largely because annuities tend to be expensive and difficult to understand.

Then there’s the question of whether you can be sure of getting payments 30 or 40 years in the future. Annuities are backed only by an insurance company’s promise to pay; insurer failures are rare, but they do happen.