Few adults would go without auto, home, life or health insurance. But the kind of insurance that protects against the risk of running out of money in old age is still greatly underutilized. It’s called a deferred income annuity or a longevity annuity.
Economists are looking at ways to increase its use, as Congress considers laws that would pave the way.
Most people planning for retirement should strongly consider an income annuity, and a Brookings Institution study (opens in new tab) confirms that. Since the study was released in 2019, economists and retirement experts at Brookings (opens in new tab) have continued to advocate for annuities that would pay income to retirees, particularly people aged 80 and above.
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Congress has also moved toward passing legislation that would remove barriers to some income annuities, specifically required minimum distributions that have limited the benefits of lifetime annuities.
Annuities 101: How They Work
The concept behind income annuities is simple. (opens in new tab) The buyer deposits a lump sum or series of payments with an insurer. In return, the insurer guarantees to pay a stream of income in the future. That’s why it’s known as a deferred income annuity.
You can choose when your payments will begin. Most people choose lifetime payments starting at age 80 or older. Guaranteed lifetime income is a cost-effective way to insure against the risk of running out of money during very old age.
The main disadvantage is that the annuity has no liquidity. You’ve transferred your money to an insurance company in exchange for a guarantee of future income. People who can’t afford to tie up any of their money shouldn’t buy a deferred income annuity.
Why Consumers Aren’t Buying
Given that traditional company pensions have largely gone away, there should be great demand for income annuities, Martin Neil Baily of Brookings and Benjamin Harris of the Kellogg School of Management write in their new study. But there isn’t, for a number of reasons.
- People overestimate their ability to invest money wisely.
- They’re also concerned that if they don’t live long enough, the annuity won’t be worth the cost. But that’s a wrong-headed view, because it’s the insurance that’s the most valuable aspect of the annuity, according to Baily and Harris. The value is in the stability and guarantee of lifetime income offered by the product. If your house never burns down, you wouldn't think that you wasted money on homeowners insurance. A lifetime income annuity insures us for the possibility of a longer-than-average lifespan.
- And the topic is confusing to consumers, in part because of the terminology. Annuities include both income annuities as well as fixed, indexed and variable annuities that are primarily savings or investment vehicles, the study authors point out.
What Annuities Do Well
Why do deferred income annuities work so well? Income deferral is a key part of the equation. The insurer invests your money so it grows until you begin receiving income. For instance, if you buy an annuity at age 55 and don’t start income payments until 85, you reap the advantage of 30 years of compounded growth without current taxes.
The longer you delay taking payments and the older you are when you start taking them, the greater the monthly payout.
Second, buyers who do not live to an advanced old age subsidize those who do. Such risk-sharing is how all insurance works, whether it’s home, auto or longevity insurance.
How They Fit into a Retirement Plan
A deferred income annuity provides unique flexibility in retirement planning (opens in new tab). Suppose you plan to retire at 65. You can use part of your money to buy a deferred income annuity that will provide lifetime income starting at 85, for example. Then, with the balance of your retirement money, you only need to create an income plan that gets you from 65 to 85 instead of having to make your money last indefinitely.
Secure Act 2.0
Even Congress is paying more attention to annuities and their role in retirement. The House of Representatives has passed the Securing a Strong Retirement Act, dubbed the SECURE Act 2.0 (opens in new tab), a followup to retirement reform legislation enacted in December 2019. The original law took steps to allow the use of annuities in retirement savings plans. The new law contains further reforms to encourage annuities.
Among the reforms are changes to address qualifying longevity annuity contracts, also known as QLACs (opens in new tab). These are deferred annuities funded by money from qualified retirement accounts. QLACs were created through regulations issued by the Treasury Department in 2014. A big advantage of QLACs is that the money used to fund the annuity doesn’t count when determining required minimum distributions and the income can be delayed until age 85. However, because of limitations in the law, the regulations restricted QLAC owners to investing only the lesser of $135,000 or 25% their retirement account balance in a QLACs.
The SECURE Act 2.0, which still needs Senate approval, would repeal the 25% limit, which Congress views as an impediment to the growth of QLACs.
Another reform in the new law would allow annuity administrators to invest in exchange-traded funds (opens in new tab).
Although ETFs are widely available through retirement plans and IRAs, Treasury regulations currently restrict their use in variable annuities. The new law directs the Treasury Department to update its regulations to allow ETFs to be offered in annuities.
Updated by Kiplinger staff on May 4, 2022.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
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