Until inflation hit, many retirees were simultaneously obsessed with two key issues, at least as far as their finances were concerned: first, making sure they didn’t outlive their assets; and second, pay more taxes than necessary.
So-called qualified longevity annuity contracts, a type of deferred annuity geared toward tax-deferred retirement accounts, seem tailor-made to solve both problems. On the longevity front, QLACs provide a lifetime income stream and can therefore be used to supplement the lifetime income that most retirees receive from Social Security. QLACs also provide tax assistance. The amount the retiree directs into QLAC – up to 25% of their portfolio or $145,000, whichever is less – is subtracted from the amount used to determine the minimum required distributions on tax-deferred accounts that begin to Age 72 This, in turn, can help reduce a retiree’s tax bills in the years before QLAC payments start.
Yet, while QLACs can help address major risk factors for retirees, they’re not perfect. QLACs are fixed annuities (non-variable or fixed indexed). And like anything with a fixed payment, they are vulnerable to inflation risk. QLAC buyers can add inflation protection by purchasing riders, but this protection will necessarily result in a lower starting withdrawal amount. Additional protections – to ensure a spousal benefit or payments over a period of time, for example – will further reduce the amount of the payment. Annuity buyers also face other risks, including insurance company risk and interest rate risk, as well as opportunity costs, as assets directed to a QLAC n simply won’t have the potential to grow.
To understand QLACs, it is first useful to be familiar with deferred income annuities in general, because that is what a QLAC is. Unlike immediate annuities, whose payments begin immediately in exchange for a lump sum of assets, deferred income annuities begin making payments at a later date, often at age 80 or 85. Deferred annuities elegantly deal with longevity risk by allowing the retiree to ensure that their portfolio can be sustained over a fixed time horizon, for example, when retirement begins between age 65 and 85, when the income stream from pension begins. The deferred annuity can help provide income for the period beyond, however long.
But despite this allure, retirees had no strong incentive to direct money from their IRAs or company retirement plans into deferred annuities before QLAC was created in 2014. That’s because any amount that the retiree paying into such an annuity would still be counted. in his RMD amount, even if the retiree would no longer have access to these funds. The presence of the deferred annuity, unavailable for withdrawals until a later date, would effectively result in a higher withdrawal of remaining assets, necessitating higher taxes and possibly 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 QLAC because it relies on what is called qualified funds (traditional tax-deferred IRAs and company retirement plan assets, not Roth IRAs or legacy IRAs) to purchase a longevity pensionand annuities are inherently contracts between individuals and insurers. Since the amount of the annuity would be subject to tax upon eventual withdrawal, it would satisfy the RMD rules even if the retiree did not withdraw money from the annuity right away. A purchase of QLAC would also reduce the amount of assets subject to RMD accordingly. When annuity payments begin, they are taxed at the investor’s ordinary tax rate.
How a QLAC could help a plan
To illustrate how a QLAC might work in the context of a real retirement plan, suppose that Kate, 70, has an IRA portfolio of $1 million and wants to receive $5,000 per month, pre-tax, from all sources. : social security, portfolio withdrawals, and possibly an annuity.
She currently receives $3,200 a month from Social Security and withdraws about $1,800 a month from her IRA to meet her additional living expenses. She also plans to direct part of her IRA to a QLAC. The maximum she can put in a QLAC is $145,000. (QLAC’s other limit, 25%, would allow her to make more money, but the limit is the lesser of $145,000 or 25% of retirement account funds.) If she were to start QLAC payments at age 80, she would receive just under $2,000 a month in annual income for the rest of her life, according to estimates by rentesimmediates.com. If she were to start payments at age 85, her monthly annuity income would be over $3,500. In contrast, income of $145,000 in an immediate annuity – with payments beginning immediately – would amount to $845 per month.
Even though the annuity will take a stake in Kate’s portfolio, knowing that the annuity income will provide her with a healthy income stream later on may 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 of her wallet than she currently plans. Additionally, the QLAC brings Kate’s RMD subject account balance back to $855,000 – her original balance of $1 million minus the annuity amount of $145,000. When RMDs finally start in two years, at age 72, they will be calculated from this lower amount. Plus, she wouldn’t have to worry about taxes on the annuity income for another 10 or 15 years, depending on when she decides to pay for it or start the payments.
Given these attractions, why isn’t everyone racing to buy a QLAC?
On the one hand, the assets used to buy the annuity could confer longevity protection and tax advantages, but they will forgo further growth. As Michael Kitces points out, QLAC purchasers must live well beyond the 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 advantages of deferring RMDs are illusory.)
Besides the issue of lost growth, there is a risk that the annuity buyer is spectacularly unlucky. A retiree who dies at age 83 after purchasing a deferred annuity with income starting at age 85 will have given up part of her portfolio without any benefit. The retiree who dies at age 87 after the annuity income begins at age 85 will also not have received their fair share. Potential annuity buyers can protect themselves against these outcomes by purchasing an annuity to cover two lives (eg married couples) or to guarantee payments over a specific number of years. But this additional protection reduces the benefits accordingly. Adding a second life to Kate’s $145,000 contract (to cover the life of her 70-year-old husband) takes payments starting at age 85 at $2,000 a month, compared to $3,500 a month for her life alone. Adding a “certain term” — to ensure payments run for at least 10 years, regardless of the partners’ death dates — further reduces payments to $1,700 per month.
Even if Kate is able to put aside her worries about not getting her fair share from her annuity purchase, inflation is another key risk factor. After all, rising prices erode the purchasing power of annuities. Annuity buyers can add inflation protection, but again the cost reduces the benefits accordingly. If Kate adds a 4% annual cost-of-living adjustment to her contract, her severance benefit would be reduced to $2,900 in starting income at age 85, down from $3,500 initially without the inflation (for Kate’s lifetime only).
Interest rate risk is also present. The insurance company determines annuity payments based on its expectation of what it will be able to earn from annuity purchasers’ funds. Although annuity payments have increased slightly over the past year to reflect rising interest rates, they are still quite low by historical standards. If Kate buys now, there is a risk that she will get a lower payment than if she had waited and rates – and therefore payments – have risen.
Insurance company risk is another factor, especially since deferred annuities will not begin to be paid until a later date. This underscores the importance of researching the financial strength of an insurer before purchasing an annuity. AM Best, Kroll, Moody’s, Standard & Poor’s and Fitch all provide financial strength ratings, although they all use different rating systems.
One option to manage some of these risks, particularly interest rate risk and insurance company risk, is to purchase the annuity over a period of years. This 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 an insurer facing financial difficulties. On the other hand, a “laddered” annuity portfolio undermines one of the main advantages of an income stream from an annuity: simplicity. In addition, the potential purchaser of a ladder annuity portfolio would likely want to keep these assets fairly liquid, which would reduce the portfolio’s return in the interim.
Take away food
In the end, the attractions of QLACs are mixed. Affluent retirees might appreciate the deferral potential of RMD, but they are less likely to need or appreciate the lifetime income benefit. Meanwhile, less affluent retirees might appreciate the lifetime income aspect of a QLAC, but place less emphasis on the tax features.
Because an annuity purchase is complicated and irrevocable (almost), hiring a paid financial planner for objective advice can be money well spent. Ideally, this adviser would have no vested interest in either part of the decision – the compensation for the purchase itself (i.e. the insurance company staff) or Fees on the remaining portfolio (i.e. advisors charging a percentage of assets).