A few weeks back, I gave a brief overview of the Annuity vs. 401k argument. While I pointed out that you can make a case for either product in retirement, I didn’t really go into the math. Today, we’ll crunch some numbers and hopefully give you the information you need to make an informed decision that helps fund your retirement for good!
Annuity vs. 401k: the comparison
These two products are a little bit different, so the comparison isn’t as easy as ones we’ve made in the past. Try to stay with us as we take a deep dive.
For the sake of this comparison, we’re going to assume that a 401k wins out during the working years. At retirement, the individual below has the option of converting some of their hard-earned tax-deferred loot into an annuity, and they just aren’t sure if they should do it. Let’s check that math.
As you can see above we have 4 columns. The first is the year. For the sake of this scenario our investor will use a 30-year timeline. Column 2 shows the 401k at $1MM even at age 59.5 and then 30 years of growth at 6%. Column 3 shows the growth of the 401k after buying a $250k annuity. Column 4 is the cumulative annuity payments on an SPIA quoted by immediateannuities.com. This SPIA quote was ran using a 59 year old male in Colorado with payments starting in Jan 2024 and lasting for life. Column 4 was not reinvested, because why would you sell $250k of your 401k just to buy a $250k annuity and then buy more stocks? Makes no sense at all.
It’s pretty clear after running some very basic numbers that buying an annuity as a simple supplement to your 401k is not a great plan. Sure, you paid $250k and over 30 years the insurance company paid you back $540k. One could argue that you made $290k. But in reality, you lost nearly $1MM in growth compared to the 401k. That’s an awful lot of money to give up, especially at a fairly pedestrian 401k return of 6%. In this scenario, the SPIA only returned 3.86% annualized. Today, you can manage 5.5% using a High Yield Savings Account (HYSA).
So why would someone buy an annuity instead of keeping their 401k?
Okay, so we’ve given you some very basic numbers to help set the scene. I get it, you’re going to criticize my math and argue that I’m missing some tax savings or that I’m not using the right kind of annuity. Someone could even make the argument that I’m using confirmation bias, which I probably am to be honest. But sometimes simple math is the best. If I need to build extensive formulas that only AJ Sheff would understand to convince you of this, it’s probably too complicated! Oftentimes the simplest solution is the best.
Now, let’s not throw the annuity out completely. The scenario we ran above is a pretty well-off investor with a $1MM 401k balance. With this kind of balance they’ll likely be getting a healthy Social Security benefit as well. BUT, what about the person who has limited 401k savings and has a clear gap between their income and obligations at retirement? This is the person where the annuity vs. 401k argument takes a different shape. Provided they have the funds, they can buy an annuity that fills their spending gap so they have some breathing room. For many people, this could be the difference between a good nights sleep and lying awake trying to figure out how you’ll eat.
Personal Finance is PERSONAL
I can’t stress this enough. Personal finance is named appropriately. I can sit here and write article after article telling you what I think you should do. But that’s just my perspective, and there’s a pretty good chance our upbringing, professional aspirations, and financial pictures look nothing alike. Because of that, you must study personal finance to try and find the best approach for you. There is no magic solution or only one way to do this. The annuity vs. 401k argument, much like many others, will be ultimately decided by YOU. Hopefully we’ve helped you make a more informed decision.