New Annuity Product Provides an Income Stream for a Long Life
Federal rules now allow taxpayers to invest a portion of their retirement accounts into a longevity annuity.
More than half of retirees rank outliving their savings as their top worry in retirement, according to a recent survey. But will this fear motivate individuals in their mid sixties to plunk down cash for a hefty guaranteed income stream that won't begin until their mid eighties?
Thanks to new rules by the federal government, a growing number of insurance companies are betting that retirees will do just that. Insurers are offering an annuity product that retirees can buy for their IRAs and employer-sponsored retirement plans, such as 401(k)s. Ten insurers -- among them Guardian Life, MetLife and Principal Financial -- are selling qualified longevity annuity contracts, known as QLACs.
A QLAC is a type of deferred income annuity, which racked up $2.68 billion in sales in 2014, up from $1.03 billion in 2012, according to the LIMRA Secure Retirement Institute. With a deferred income annuity, you pay an insurance company a lump sum in return for a lifetime monthly payment that begins at a specified time in the future.
The longer you defer the payments, the bigger they will be. A 65-year-old man who invests $100,000 in a contract that starts payments at age 75 could get $1,299 a month, according to www.immediateannuities.com. Delay payments to start at age 85, and he'll get $4,477 a month. A deferred income annuity is an "effective way to assure against outliving your money," says David Blanchett, head of retirement research for Morningstar Investment Management.
A QLAC differs from a typical deferred annuity because you buy it for an IRA or 401(k) under rules set by the U.S. Treasury last year. Those rules allow a taxpayer to place up to 25% of retirement-plan assets -- up to a maximum of $125,000 -- in a QLAC, and payments must start no later than age 85. A retiree who turns 70 1/2 does not take required minimum distributions on the money in the QLAC until the payouts begin. At that point, the payments will be added to the RMDs from the retiree’s other retirement plans, and income taxes will be owed on the total.
Indeed, some insurers claim that a QLAC is a good way to defer RMDs and possibly reduce taxes. "Part of our core marketing strategy is the management of RMDs and taxes, and lifetime income," says Chin Kim, assistant vice-president of advanced marketing for the Retirement Solutions Division of Pacific Life Insurance. Kim says deferring income from RMDs could help some people lower the tax bite on Social Security benefits and avoid income-related Medicare Part B premiums before QLAC payouts begin.
A Pacific Life brochure looks at a 65-year-old man, Dave, who has a $500,000 IRA and is in the 30% tax bracket. In one scenario, he decides to leave his IRA alone; in another, he invests $125,000 in a QLAC, which will pay him $37,673 a year starting at age 85. The non-QLAC assets in both IRAs grow at 6% a year.
Between ages 70 1/2 and 84, Dave pays $41,409 less in taxes with the QLAC than with the IRA without the QLAC. "If he's taking less in RMDs, he's taking less in taxable income," Kim says. Between ages 85 and 90, Dave's after-tax income will total $345,073 with the QLAC, compared with $249,124 without the annuity.
Better Off With Stocks and Bonds?
But some retirement researchers question the value of a QLAC as a strategy to defer RMDs and reduce taxes. While longevity annuities can help some retirees avoid running out of money, a QLAC is a "terrible way" to defer RMDs, says Michael Kitces, director of financial planning research at Pinnacle Advisory Group, in Columbia, Md. "Of course, you're paying less in taxes for those first 15 years -- you're getting no returns for 15 years," Kitces says. "You're throwing away 15 years of growth" by investing in a QLAC. And you don't recover your original investment until several years after payouts begin, he says.
Kitces says an investor could be well into his nineties or older before the QLAC generates as much after-tax wealth as the same-size investment in a diversified portfolio of stocks and bonds. Kitces compares two 69-year-old men who are in the 25% tax bracket. One invests $100,000 in a QLAC, with annual payouts of $36,920 that are to begin at age 85. (This QLAC has a return-of-principal death benefit, meaning that the designated beneficiary will get the principal back minus any payouts to the retiree.) The other man invests $100,000 of his IRA in a portfolio returning 8% a year, and he starts taking RMDs at age 70 1/2. After-tax distributions from the IRA and after-tax QLAC payments go into a taxable brokerage account where interest, dividends and capital gains are taxed at 20%.
The QLAC investor must live until age 105 before the annuity, with its relatively low rate of return, produces as much after-tax total wealth as the non-QLAC IRA, Kitces says. (The QLAC investor pulls ahead at age 93 if the non-QLAC's investments return 5% a year.) Besides forgoing years of growth, Kitces says, a QLAC only defers taxes -- it doesn't avoid them. "The tax bill jumps when the QLAC starts up," he says. (In the Pacific Life example, the QLAC investor pays $41,119 more in taxes between ages 85 and 90 than the retiree without the QLAC -- about the same amount he saved when he deferred RMDs from ages 70 1/2 to 84.)
Although Kitces dismisses a QLAC's value as a way to avoid RMDs, he says a deferred annuity could make sense as a hedge against longevity. Both he and Blanchett say a QLAC could be a good investment for a retiree whose portfolio is heavily invested in low-return bonds. "If you're a bond investor, the QLAC would be more compelling," Kitces says. A QLAC's returns are about two to three percentage points higher than returns on bonds, but they are lower than returns of a typical diversified portfolio, Kitces says.
Your investing profile is just one consideration before you decide on a QLAC. Look at your likely life span. And review your other guaranteed sources of income. "Delaying Social Security will create even more income," Blanchett says. "The first thing you should do is delay Social Security and then decide whether to look at the annuity."
If you would like to buy a QLAC, your gender could determine whether you should buy it inside an IRA or inside a 401(k). Employer-based retirement plans are required to price annuities at the same rates for men and women, even though women tend to live longer than men. Annuities bought in IRAs or outside retirement plans can be priced based on gender -- with women getting lower payouts for the same premiums as men. "If you're female, you could be better off buying inside a 401(k)," Blanchett says. "You could get an increase in income." A man would probably get a better price if he bought a QLAC for his IRA, he says.