Can a Qualified Longevity Annuity Contract Aid Your Retirement Plan?
Examining the pros and cons of this type of tax-deferred longevity protection.
Until inflation came on the scene, many retirees were simultaneously obsessed with two key issues, at least with respect to their finances: First, making sure they didn’t outlive their assets; and second, paying more in taxes than they needed to.
So-called qualified longevity annuity contracts, a type of deferred annuity geared toward tax-deferred retirement accounts, seem tailor-made to address both issues. On the longevity front, QLACs provide a stream of lifetime income and therefore can be used to augment the lifetime income that most retirees receive from Social Security. QLACs provide an assist on the tax front, too. The amount that the retiree steers into the QLAC—up to 25% of his or her portfolio or $145,000, whichever is less—is removed from the amount that is used to determine the required minimum distributions on tax-deferred accounts that commence at age 72. That, in turn, can help reduce a retiree’s tax bills in the years before the QLAC payments commence.
Yet as much as QLACs can help address key risk factors for retirees, they’re not perfect. QLACs are fixed annuities (not variable or fixed indexed). And like anything with a fixed payout, they’re vulnerable to inflation risk. Purchasers of QLACs can add inflation protection by purchasing riders, but that protection will necessarily result in a lower starting withdrawal amount. Additional protections—to ensure a spousal benefit or payments over a certain time period, for example—will further curtail the payment amount. Annuity purchasers face other risks as well, including insurance-company risk and interest-rate risk, as well as opportunity costs, in that assets steered into a QLAC simply won’t have the potential to grow.
To understand QLACs, it’s first helpful to get a grounding in deferred income annuities generally, because that’s what a QLAC is. In contrast with immediate annuities, which begin payments immediately in exchange for a lump sum of assets, deferred income annuities begin making payments at some later date, often at age 80 or 85. Deferred annuities elegantly address longevity risk by allowing the retiree to ensure that his or her portfolio is maintainable over a fixed time horizon—for example, when retirement commences at age 65 to age 85, when the stream of income from the annuity begins. The deferred annuity can help supply income for the period beyond that, however long it might be.
But despite that attraction, retirees didn’t have a strong incentive to steer money from their IRAs or company retirement plans into deferred annuities prior to the QLAC’s creation in 2014. That’s because any amount that the retiree put into such an annuity would still be counted in his or her RMD amount, even though the retiree would no longer have access to those funds. The presence of the deferred annuity, unavailable for withdrawals until some future date, would effectively drive a higher withdrawal from the remaining assets, necessitating higher taxes and perhaps premature depletion of liquid assets.
Yet in 2014 the Treasury Department ruled that retirees could take a portion of their retirement accounts and put it into a deferred annuity, up to the aforementioned limits. The mechanism was called a QLAC because it relies on so-called qualified funds (traditional tax-deferred IRA and company retirement plan assets, not Roth IRAs or inherited IRAs) to purchase a longevity annuity, and annuities are inherently contracts between individuals and insurance companies. Because the amount in the annuity would face taxes upon the eventual withdrawal, it would satisfy the RMD rules even though the retiree wasn't taking money from the annuity right away. A QLAC purchase would also reduce the amount of RMD-subject assets accordingly. When the annuity payments commence, they would be taxed at the investor's ordinary income tax rate.
How a QLAC Could Aid a Plan
To illustrate how a QLAC might work within the context of a real retirement plan, let’s assume that 70-year-old Kate has a $1 million IRA portfolio and would like to receive $5,000 per month, pretax, from all sources: Social Security, portfolio withdrawals, and possibly an annuity.
She is currently receiving $3,200 a month from Social Security and withdrawing about $1,800 a month from her IRA to meet her additional living expenses. She is also considering steering a portion of her IRA into a QLAC. The most she can put into a QLAC is $145,000. (The other QLAC limit, 25%, would enable her to annuitize a larger sum, but the limit is the lesser of $145,000 or 25% of the retirement account funds.) If she were to begin payments from the QLAC at age 80, she'd receive just shy of $2,000 a month in annual income for the rest of her life, based on estimates from immediateannuities.com. If she were to begin payments at age 85, her monthly income from the annuity would be more than $3,500. By contrast, income from $145,000 in an immediate annuity—with payments beginning straightaway—would amount to $845 per month.
Even though the annuity will take a bite out of Kate’s portfolio, knowing that the annuity income will deliver a healthy stream of income later on can give her a greater sense of peace with her withdrawal rate in her pre-retirement years, especially if a bad market materializes or she decides she would like to spend more from her portfolio than she is currently forecasting. Additionally, the QLAC takes Kate’s RMD-subject account balance down to $855,000—her initial $1 million balance less the $145,000 annuity amount. When RMDs eventually commence in two years, at age 72, they’d be calculated off of that smaller amount. Moreover, she wouldn’t have to worry about taxes on the annuity income for another 10 or 15 years, depending on when she decides to annuitize, or start payments.
Given those attractions, why isn’t everyone running out to buy a QLAC?
For one thing, the assets used to purchase the annuity might confer longevity protection and tax benefits, but they'll forgo further growth. As Michael Kitces points out, QLAC purchasers have to live well past average life expectancy for the annuity to offer a better "return" than would be available by investing in a balanced portfolio inside an IRA. (He further argues that the tax benefits of deferring RMDs are illusory.)
Apart from the question of forgone growth, there’s a risk that the annuity buyer could be spectacularly unlucky. The retiree who dies at age 83 after buying a deferred annuity with income commencing at age 85 will have forgone a portion of her portfolio with no benefit whatsoever. The retiree who dies at age 87 after annuity income begins at age 85 won’t have gotten her fair share, either. Would-be annuity purchasers can protect against those outcomes by purchasing an annuity to cover two lives (for example, married couples) or to guarantee payments over a specific number of years. But that added protection reduces benefits accordingly. Adding a second life to Kate’s $145,000 contract (to cover her 70-year-old husband’s lifetime) takes payments commencing at age 85 to $2,000 a month, down from $3,500 a month for her life only. Adding a “term certain”—to ensure that payments flow for at least 10 years regardless of the partners’ dates of death—further reduces payouts to $1,700 a month.
Even if Kate is able to set aside her worries about not getting her fair share from her annuity buy, inflation is another key risk factor. After all, rising prices eat away at the purchasing power of annuity income. Annuity purchasers can add on inflation protection, but here again, the cost shrinks benefits accordingly. If Kate adds a 4% annual cost-of-living adjustment to her contract, her starting benefit would be reduced to $2,900 in starting income at age 85, down from $3,500 initially without the inflation adjustment (for Kate’s life only).
Interest-rate risk is also in the mix. The insurance company determines annuity payouts based on its expectation of what it will be able to earn on annuity purchasers’ funds. While annuity payouts have picked up a bit over the past year to reflect rising interest rates, they’re still quite low by historical standards. If Kate purchases now, there’s a risk that she’d obtain a lower payout than if she waited and rates—and in turn payouts—trended up.
Insurance company risk is another factor, particularly given that deferred annuities won’t begin paying out until some later date. That underscores the importance of researching an insurer’s financial strength before making an annuity buy. A.M. Best, Kroll, Moody’s, Standard & Poor’s, and Fitch all provide financial strength ratings, though they all use different systems for evaluation.
One option for managing some of these risks—especially interest-rate and insurance company risk—is to make the annuity buy over a period of years. That helps ensure annuity purchases in a variety of interest-rate environments. It also allows the annuity buyer to purchase from more than one company, thereby mitigating the risk of any one insurer facing financial issues. On the other hand, a “laddered” annuity portfolio undermines one of the key benefits of a stream of income from an annuity: simplicity. Moreover, the prospective purchaser of a laddered annuity portfolio would presumably want to keep those assets fairly liquid, cutting into the portfolio’s return in the meantime.
In the end, QLACs' attractions are mixed. Wealthy retirees might appreciate the potential for RMD deferral, but they're less likely to need or value the lifetime income benefit. Meanwhile, less-affluent retirees might appreciate the lifetime income aspect of a QLAC but value the tax features less.
Because an annuity purchase is complicated and irrevocable (or close to it), engaging a fee-only financial planner for objective guidance can be money well spent. Ideally, that advisor would not have a vested interest in either side of the decision—remuneration from the purchase itself (that is, insurance company personnel) or fees on the remaining portfolio (that is, advisors who charge a percentage of assets). Could Your Portfolio Use a Makeover? Submit your information for a chance to have Christine Benz review your portfolio and provide improvement suggestions based on your needs.