Peace of Mind at a Price: Carefully Evaluating Qualified Longevity Annuities
Longevity annuities are experiencing an increase in visibility due to recent tax law changes, promising guaranteed income for life and fewer taxes through the use of a Qualified Longevity Annuity Contract, or QLAC.
For those approaching or already well into retirement, this may seem like the perfect solution to quelling those mounting fears of outliving your savings.
But as the old saying goes, just because you can, doesn’t mean you should. This new opportunity, as with any choice involving your financial plan, should be carefully evaluated using an objective, evidence-based approach, with your overall financial goals in mind. In this Viewpoint, we will review the features of QLACs, and discuss potential risks and benefits to investors.
First, it’s important to understand what longevity annuities are and the fine print around QLAC requirements:
There are two types of annuities – variable and fixed. Variable annuity contracts are not available for use in a QLAC, and will not be the focus of this article.
A fixed annuity is a contract between you and an insurance company, under which you make a lump-sum or series of contributions to the insurance company. In return the insurance company agrees to pay you a minimum rate of interest on your contribution, plus a series of periodic payments that will last for a defined number of years, or an indefinite number of years (such as your lifetime).
When payments begin at some point in the future rather than immediately, it is known as a deferred annuity.
A deferred fixed annuity that provides payments for the life of the individual or couple is referred to as a longevity annuity. Longevity annuities are designed to provide a reliable stream of income should one live longer than expected.
Recently, regulations changed to allow the sale and purchase of longevity annuity contracts in IRAs and qualified retirement plans. This is called a Qualified Longevity Annuity Contract, or QLAC. This created an exception to the Required Minimum Distribution rules that apply to these accounts, allowing the RMD to be deferred until the age of 85 instead of age 70.5 on the portion of the funds in the QLAC.
A longevity annuity must meet the following requirements to be eligible as a QLAC:
- The amount of premiums paid cannot exceed the lesser of $125,000 or 25 percent of an individual’s IRA.
- Payments from the QLAC must start no later than age 85.
- The QLAC must provide fixed payments. A cost of living adjustment rider may be purchased.
- The QLAC cannot have a cash surrender value once purchased. In other words, it must be irrevocable and illiquid, however it can have a return-of-premium death benefit payable to heirs as a lump sum or stream of income.
What you need to know
Before you consider leveraging a portion of your retirement savings to purchase a QLAC, it extremely important to understand the risks:
- Inflation risk – Inflation can degrade the purchasing power of the annuity’s guaranteed income. Cost of living adjustments may be offered by the insurer, but can diminish the amount of money available in your initial payments.
- Mortality risk – A longevity annuity is essentially a hedge that you will live to a very old age. If you pass away before the principal and earnings are realized, the balance that remains after your death becomes the property of insurance company unless you have purchased a return-of-premium death benefit (which significantly lowers your returns).
- Illiquidity – Once in place, the QLAC is irrevocable and illiquid, meaning the money you have contributed cannot be accessed again.
- Insurer risk – The agreed-to payments are largely dependent on the strength and stability of the insurance company, and while the solvency of an insurer is unlikely to be an issue, there is no guarantee that payments will be made should the company have financial problems or cease to exist.
- Opportunity cost – While reducing taxes by deferring withdrawals for up to fifteen additional years may seem attractive, it is important to understand the performance of the QLAC in the greater context of investment options such as a balanced portfolio.
According to a recent analysis, a 53-year-old couple who purchases a joint longevity annuity for $105,800 with a return-of-premium death benefit and payments beginning at age 83 will not receive the initial principal back until age 86, 33 years after making the investment. By age 90, the after-tax internal rate of return is still only 3.45%, and by age 99 the return is 5.15%.
In comparison, Truepoint’s 70/30 portfolio projects a long-term 6.45% net-of-fee return, and provides significantly more cash flow than a QLAC over the life of the investment.
When QLACs can make sense
The two main benefits of the QLAC are the ability to guarantee income for life (provided the insurer has the ability to pay), and the potential tax advantage of deferring the Required Minimum Distribution on the portion of the QLAC.
We are constantly evaluating the best methods for helping our clients meet their goals. Presently, we don’t believe there is a compelling reason for most of our clients to use QLACs, or any form of annuity to meet their financial needs. Other options, such as a low-cost diversified portfolio, are simply more effective financial tools. Only under very limited circumstances – where spending is high relative to available assets, or there is high aversion to risk and assets would otherwise be placed in cash – would a fixed annuity be an appropriate solution.
The new tax laws offer more choices for how to leverage your qualified retirement plans and IRAs. But beware of the allure of insurance products aimed at anxieties that naturally persist when we think about aging. As with any major decision regarding your financial plan, we are here to help you objectively evaluate these opportunities in the broader context of your overall goals.