Should You Add Longevity Protection to Your Retirement Plan?

Running out of money consistently rates as one of retirees' top worries: When respondents in anAllianz survey were asked which they feared more, death or outliving their assets more, 61% said they were more worried about running out of dough.

Thus, it's probably no surprise that retirees and pre-retirees are so interested in maximizing any income streams that will last throughout their lifetimes--even if they end up living to be 100. Articles about wringing the most lifetime income, for example, consistently garner some of the highest page views on Morningstar.com.

Lifetime income sources like Social Security, pensions, and income annuities provide a hedge against outliving one's assets, guaranteeing that there's at least some money coming in the door even when investors' portfolios begin to run low. Regulations from the U.S. Treasury Department released earlier this month pave the way for pre-retirees and retirees to obtain additional longevity protection by allowing them to steer part of their IRAs into what are called qualified longevity annuity contracts, or QLACs.

In contrast with immediate annuities, where you fork over a lump sum of cash and the insurer immediately begins sending you a stream of payments that will last as long as you live, a longevity annuity starts making payments at some later date. For example, you might buy the longevity annuity when you're 65, but it might not begin making payments to you until age 85. Because the time period that the deferred annuity will pay out is shorter than is the case with an immediate annuity--and because the insurer can earn some interest on your premium before it has to start paying you--it's only logical that longevity-annuity purchasers can receive a substantially larger annual payment with far less of a cash outlay than would be the case for immediate-annuity purchasers.

The new regulations put some specific parameters around the use of longevity annuities within IRAs. The annuity payments must commence by age 85 at the latest, and the premiums paid for the annuity cannot amount to more than 25% of the individual's total balance, or $125,000, whichever amount is less. The annuity also has to be very plain-vanilla: Inflation-adjustment riders are allowable, but the payments can't be variable or equity-indexed.

Importantly, the new regulations also clear up what had previously been the key impediment to putting longevity annuities in IRAs and company retirement plans: the role of required minimum distributions. Under the previous rules, because the longevity annuity doesn't begin paying you anything until later in retirement--often well past the RMD beginning date of age 70 1/2--any money that you had sunk into it could not be used to meet RMDs. Under the new regulations, the longevity annuity is deemed to satisfy the RMD requirements. Because retirees have much of their portfolios inside so-called qualified plans, the new regulations effectively clear the way for longevity annuities to become much more prevalent in retirees' plans.

'The Most Pure Play of Hedging Longevity Risk'
For those concerned about outliving their assets because they could live a very long time--well into their 90s, for example--longevity annuities can help provide peace of mind. A retired investor who owns such an annuity can plan for his portfolio of stocks, bonds, and funds to last for through a given time horizon--say, until age 85. If the individual is still living beyond that date, the annuity payments will help supply income in addition to whatever cash flow the (possibly dwindling) investment portfolio can provide.

David Blanchett, head of retirement research for Morningstar Investment Management, says that QLACs "are the most pure play of hedging longevity risk" and are more effective than immediate annuities for the purpose of longevity-risk hedging. "Many retirees don't need a guaranteed [source of] income immediately; they want certainty around how long they have to plan for their savings to last," Blanchett says. "That is why longevity annuities are so attractive."

Michael Kitces, a partner and director of research for Pinnacle Advisory Group, agrees that longevity annuities beat immediate annuities when it comes to hedging against longevity risk. The best candidate for such a product, Kitces says, "is someone who is specifically afraid of living well into his 90s and beyond and is concerned he'll have enough money to fund a retirement that long."

Balancing Behavioral and Financial Factors
Despite those attractions and the fact that longevity annuities will be more readily available via IRAs, the products aren't without potential drawback. Just as a purchaser of an immediate annuity faces the chance that he will die before receiving a fair share of payments, the buyer of a longevity annuity risks dying before or shortly after payments commence.

The psychological risks of parting with a sum of money that never provides a benefit is one reason that many retirees avoid the products, even though data indicate that annuities can be an attractive part of retirees' tool kits.

Kitces points out that some products do offer a death-benefit guarantee, so that your estate receives at least your principal if you never receive payments from the annuity. But, Kitces says, adding in this protection will also reduce the benefits you'd receive if you lived. "If you get guarantees for both sides--if you live, and if you die--you just end up with a very mediocre combination guarantee that doesn't do much for either."

Kitces also noted in a post on his Nerd's Eye View blog that given today's low interest rates, longevity annuities don't necessarily offer an attractive "return" relative to conservative investment types. In other words, unless you live a very long time and are able to wring a large amount of payments from the annuity, you may have been better off avoiding the products and just investing conservatively instead.

But Blanchett believes that would-be purchasers of longevity insurance are better off thinking of it as an insurance product. You may well lose money on the deal, but you've obtained something that's impossible to quantify but potentially even more valuable: peace of mind. "Someone buying this should be buying it as a pure insurance policy, and shouldn't be too focused on the internal rate of return," he says. "I'm not saying one shouldn't be aware of the cost, but it's only part of the equation."

How Much Is Enough?
Assuming one has decided to steer a portion of a portfolio to a longevity annuity, what is the right amount to steer toward it?

For Blanchett, the timing of the start date is the key swing factor. The further the start date (and remember, 85 is the latest date for payments to start for someone buying a QLAC within an IRA), the smaller the allocation should be. He suggested that for a 65-year-old purchasing a QLAC that will commence payments at age 85, 5%-15% of the portfolio is a reasonable ballpark percentage. He also urged would-be annuity purchasers to factor in other certain sources of lifetime income, such as Social Security, when deciding how much to sink into a longevity annuity.

Kitces notes that many purchasers of longevity annuities think about the baseline living expenses they'd like the product to supply and use that to inform how much they sink into the contract. But he also points out that even as some longevity policies guarantee a cost-of-living adjustment once payments commence, they don't guarantee inflation adjustments between the time you purchase them and the time payments start. That means that forecasting how much you'll actually need "turns into a bit of a guessing game."

Blanchett also points out that the market for these products is still pretty thin and there aren't nearly as many products available as in the single-premium immediate annuity space. But given the new Treasury Department ruling, he says, "I'm guessing this will improve as [the products] increase in popularity."

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