In this article, we’ll examine how annuities can fit into target-date mutual funds and whether or not they’re a good choice for investors.

Several investors understand that target-date funds make for ideal default investments, but they don’t fully understand what they should be investing in themselves. Understanding what happens next once they begin building up savings is a bigger challenge. Investor confusion over the objective of contributing to target-date mutual funds has posed a unique problem.

In case if you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.

Target-date funds have become a particularly attractive option for those with little expertise in investing. For most retirement savers, they work especially well since they invest heavily in stocks in the early years before transitioning to a more conservative allocation as retirement nears.

Many savers, however, mistakenly believe that target-date funds offer a lifetime income benefit. One of the things that target-date funds don’t do is address the needs of those seeking a guaranteed monthly income. A few fund companies have begun introducing annuities to their target-date funds to provide a guaranteed income component. The Department of Labor (DOL) has stipulated that these funds must maintain liquidity in order to be included.

Check out our Target-Date Funds section to learn more about these funds.

As target-date funds have begun incorporating a defined-benefit aspect to their portfolios, annuities seem like a natural fit. The DOL’s fiduciary rule, which lays out that financial advisors must work in the best interests of their clients, might suggest that the addition of annuities to target-date funds is the best choice, but these products have their own set of issues.

Make sure that you are not oversimplifying the way target-date funds might operate. Click here to know the due diligence process.

Annuities may have trouble gaining acceptance within target-date funds for a few reasons.

• Complexity – Annuities often have complex structures that are difficult to understand. There are fixed and variable annuities. Some are indexed to a baseline such as the S&P 500. Some start paying immediately, while some are deferred. The multitude of different options within the annuity structure can leave investors confused about what exactly they’re investing in. In many cases, investors are left with a product that’s ill-suited to their needs.

• Cost – Annuities are notoriously expensive and there are a number of ways you could be dinged with fees. There are potential commission costs to the broker that sold the annuity, management fees if the annuity invests in mutual funds or other securities and surrender charges if you wish to get out of the annuity early. Ongoing fees could easily be 2% or more annually, an expense level that is often fraught with downsides for the investor. The DOL’s fiduciary rule, requiring that financial advisors work in their client’s best interests, would require financial advisors to clearly disclose commission and fee structures to potential clients. Once implemented, this could result in lower fees overall.

• Confusion – In a lot of cases, investors are intrigued by the notion of guaranteed income for life. For an upfront lump sum, retirees can receive a monthly income for the rest of their lives. In many ways, it gives the feeling that their financial problems have been solved. In truth, many investors end up losing money on annuities because they’re not able to recoup their initial investment. When purchasing annuities, buyers make an initial investment in exchange for a perpetual stream of monthly payments. If the buyer, however, doesn’t live long enough, the total received in monthly payments may not equal or exceed the initial investment. Even seasoned investors often have trouble understanding the risk/reward tradeoff that comes with annuities.

For target-date funds looking to incorporate them, annuities would act as another investment option within the glide path. Most funds start out investing the assets into equities with very little allocation to fixed income and over time switch over to mostly fixed income. As the target date nears, the fund may choose, for example, to invest in 50% stocks, 40% fixed income and 10% annuity. Once the target-date passes, the allocation may switch to something like 25% annuity.

TIAA is one company that has begun introducing annuities into its Target-Date Plus Models. They offer a combination of equities, fixed income and annuities in order to provide a long-term income stream. Within a retirement plan, TIAA offers employers target-date funds with the flexibility to match the needs of their employer base by offering custom glide paths and rebalancing specifications, but with the added benefit of offering options with lifetime income security.

Blackrock is another asset manager that has incorporated annuities into its series of target-date funds. As defined benefit plans such as pensions continue to disappear, Blackrock has begun using annuities as a means of adding predictability to retirement income streams.

Want to know how the difference between a readymade and a customized target-date fund? Check out this article to learn more.

Target-date funds offering annuity products are a nice next step in the target-date fund evolution. Issues of cost and complexity are currently preventing them from experiencing widespread adoption. Since the guaranteed income option is clearly something that retirement investors are seeking, it may be just a matter of time before we see annuities in many more target-date funds.

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