“If I retire, I’m 65 years old, a question is not so much how I will create money tomorrow. It’s how will I create money if I’m alive 25 years from now?”
– David Blanchett, PhD, CFA, CFP® and head of Retirement Research for Morningstar
The above quote refers to the challenges that come with planning for a long retirement. As people live longer and longer, they need to stretch out their resources over ever longer time frames. This is known as “longevity risk,” the risk of outliving your assets.
We have written a post on longevity in the past, and in this article we further our discussion by looking at one way of potentially hedging against longevity risk.
Deferred income annuities, also known as longevity insurance, have been around for a long time. The basic idea behind a deferred income annuity is that you give money to an insurance company today in exchange for a guaranteed income stream in the future. What has changed is that a ruling by the Treasury Department in 2014 now allows you to purchase a longevity annuity with retirement money (i.e. IRA or 401k), while also allowing you to defer the required minimum distribution on that money. This type of deferred income annuity is referred to as “QLAC,” qualified longevity annuity contract.
So why would the government pass this ruling and why should you care? J. Mark Iwry, deputy assistant secretary for Retirement and Health Policy, offered a nice summary in the press release of the final ruling:
“All Americans deserve security in their later years and need effective tools to make the most of their hard-earned savings. As boomers approach retirement and life expectancies increase, longevity income annuities can be an important option to help Americans plan for retirement and ensure they have a regular stream of income for as long as they live.”
Aren’t Annuities Bad?
Before we delve into how QLAC’s work, lets briefly talk about annuities. Annuities are generally frowned upon by the investing public, and with good reason. A lot of annuities are complex, loaded with fees, and sold by insurance professionals rather than bought by informed retirees. With that said, not all annuities are bad. Its value depends on the type of annuity and how it fits into your plan. Annuities are a type of insurance, and they can offer certain benefits that investing in stocks or bonds may not.
While I am obviously a bit biased, I would strongly recommend you work with a fee-only financial advisor (like Pinnacle) when trying to look at annuities. Fiduciary advisors can approach the decision from a financial planning point of view, rather than trying to sell you something to earn a commission.
Minimum Required Distributions
If unfamiliar, in the year you turn 70.5 you must start taking distributions from your retirement accounts (i.e. IRA’s and 401k’s). These are known as Minimum Required Distributions (MRD’s). The amount you must take out is based upon life expectancy tables published by the IRS. Each year the percentage that you must take out increases. When you take money out you must pay taxes on that money.
Louise turned 70.5 this year and has a retirement account balance of $500,000. Based upon the IRS table, her minimum distribution is $18,248. This amount will be subject to income tax.
Unlike some other annuities, QLAC’s are relatively easy to understand: you pay a premium to an insurance company today for the guarantee of an income stream in future years.
There are restrictions on how much money you can put into a QLAC. The maximum QLAC purchase is the lesser of:
• $125,000 (this amount is indexed for inflation in $10,000 increments) OR
• 25% of your IRA account value.
Adam is 62 with a $400,000 IRA. The most he could purchase of a QLAC is $100,000 (25% of his account balance).
The limits are also a per person limit. So for a married couple they could each purchase QLAC contracts if they both have IRA accounts.
The latest age you can defer payments under a QLAC is 85. You can begin payments sooner as well.
QLAC’s are fixed annuities. They cannot be sold as variable or equity indexed annuities. You can purchase them with inflation adjustments once the payments start as well.
Another important feature is that you can add your spouse as a joint annuitant to your QLAC. This means that the income from the annuity will last for both of your lifetimes, no matter how long either of you live. For married 65 year old couples, there is an 18% chance that one of them will live to 95, making longevity insurance a potentially more attractive proposition.
Dan and Maria are 65 and planning for retirement. Dan purchases a QLAC for $125,000 that will cover the lifetime of him and Maria. If Dan passes away before Maria, the payout continues until she passes.
One other feature that can be added to these contracts it the ability to have a death benefit. If you purchase a QLAC but pass away before payments begin, you can receive 100% of the premium back.
Jack bought a $125,000 QLAC with a Return of Premium rider when he was 65 with payments set to start at 85. Unfortunately Jack passes away at 75. Since he had the Return of Premium option, his beneficiaries can receive the $125,000 back. There is no growth on the $125,000; it is only the initial premium amount of $125,000 that is returned.
QLAC’s and MRD’s
As we mentioned above, at age 70.5 you need to start taking money out of your retirement accounts. With a QLAC however, any money that is in the QLAC is not part of the MRD equation.
Tom, age 69, has an IRA valued at $700,000. When he turns 70.5 his Minimum Required Distribution would be about $25,500. If he takes $125,000 and purchases a QLAC, the $125,000 is no longer included in the MRD calculation. He now calculates the MRD on $575,000 balance. His MRD would be $20,980.
Research from financial researcher Michael Kitces (see here) has shown that QLAC’s used solely for the purpose of deferring MRD’s isn’t a great idea. Rather, they should be viewed for their benefits as longevity insurance. That is where they have the greatest value.
How much income would a QLAC pay?
The amount that you would receive from a QLAC depends on a number of options. The primary determinants are the age you start the contact, the age you will start receiving payments, current interest rates, and whether you add a joint annuitant or not. Adding other features like inflation adjustments and return of premium will also impact the payout.
Below is a very general example with quotes received from immediateannuities.com. Quotes will vary. This is purely for illustrative purposes.
Joe and Marilyn are 65 years old. A 100% Joint and Survivor annuity with a Cash Refund would pay out about $2,500/m starting at age 85. So when they turn 85, they will receive $30,000 of guaranteed income for as long as either of them lives. If Joe passes, the payment doesn’t change, Marilyn receives the same $2,500/m. There is also a death benefit that would ensure that at the minimum the $125,000 premium is paid out in the case that Joe and Marilyn pass away early.
Why Would You Consider a QLAC?
QLAC’s are risk transfer strategies. You are transferring the risk of outliving your money to an insurance company that guarantees that they will pay you an income no matter how long you live. The ability to hedge against longevity risk is the greatest benefit of a QLAC.
QLAC’s can also serve as a hedge against market risk later in retirement. The payment is guaranteed for you no matter what may have happened in the markets during the interviewing years.
One final advantage is that by purchasing a QLAC up front in retirement, you have in some respects lessened the time frame for how long you have to relay upon your portfolio. Rather than planning for 30 years, you are planning for say 20 years, with the understanding that you will have the QLAC starting to pay out at 85.
Everything in life is a trade off, and that especially applies to QLAc’s.
One disadvantage to QLAC’s is that you have no flexibility with the money you use to purchase the QLAC. Once you purchase the annuity you have parted with that money, and can no longer access it.
You also lose the ability to invest that money, which some may not be comfortable with. While I think it’s a valid concern, I don’t believe it’s the appropriate way of analyzing annuities. Annuities are insurance, not investments. If you could invest your money and be ensured that you will have enough later in life then it would be a no brainer to invest it. However, there is no investment that can guarantee that. With a QLAC you are buying insurance to protect you against that longevity and market risk.
Another disadvantage is the potential impact of inflation. While you can purchase inflation adjustments on the income amount, that inflation adjustment only starts when the payouts start. The payment isn’t adjusted during the years in between the time you pay the premium and the payments start. If inflation increases substantially, your future income may not go as far as you had originally planned.
Lastly, “longevity insurance” protects you from living long. If you have reasons to believe you may have a shorter life expectancy, then a QLAC may not be the right option for you.
Longevity risk is something that all retirees must consider. Understanding the risks that you face in trying to stretch your money out over a multi-decade time frame can help you analyze appropriately all the different options for you, with QLAC being just one of the many.