Longevity Annuities In Retirement Planning – A Gamble That Might Pay Off Handsomely
Trusts & Estates Law Alert 11/06/14 John T. Bannen
In July of this year, the Internal Revenue Service (IRS) issued regulations concerning the use of IRA or qualified plan funds to purchase a new kind of annuity known as a Qualified Longevity Annuity Contract (QLAC).1
What is a Qualified Longevity Annuity Contract?
A QLAC is an annuity purchased from a life insurance company with retirement funds, either from an IRA account or a qualified plan, such as a profit-sharing or 401(k) plan. Like many annuities, it pays a fixed amount for the life of the annuitant. What is different about a QLAC is that the annuity starting date, instead of being at age 65 or even age 70½ when retirement benefits must usually begin, is at or just before the annuitant's actuarial life expectancy. According to the IRS regulations, the QLAC is permitted to start paying benefits as late as the first day of the month the annuitant reaches age 85.
Why Would Anyone Purchase an Annuity that Begins Paying at Age 85?
The purpose of the QLAC is to provide protection against outliving one's retirement funds. Underestimating one's own longevity, or the longevity of a spouse is a common retirement planning mistake. Fewer and fewer retired employees have an annuity as a retirement benefit. The retirement planning landscape has shifted to IRAs, 401(k) and profit-sharing plans that result in an accumulation of dollars where the retiree must invest and determine how much to spend without running out prior to death. Such accumulations are subject to overspending, unplanned investment losses, and ultimately living longer than anticipated. Using some of these retirement funds to purchase an annuity that pays for life is one way to insure that each retiree will have at least some monthly payments to supplement social security payments for life. Choosing an annuity starting date as late as age 85 increases the amount of the monthly benefit (actuarially it will be paid for a shorter period) and also gives retirement income a boost at exactly the time when the retirement income vehicle might be running on fumes if life expectancy has been underestimated.
Why Should I Buy an Annuity if I Could Make More Money in the Stock Market?
When a person purchases an annuity from a life insurance company, the insurer generally purchases fixed income investments, which will come due during the annuity payout period. Logically a fixed annuity reflects fixed income investment rates of return. Thus, a fixed income annuity will not compete favorably with a bullish stock market, but by the same token it will not suffer bearish downturns either. Annuities are not about maximizing investment returns, they are about guarantees. Periodic withdrawals from a stock oriented investment account may last for the investor's lifetime, or they may not. The annuity is guaranteed to continue payments for life. Fortunately, the retiree can choose both forms of investment: (i) some funds in an annuity which is guaranteed for life and (ii) some funds in equity investments, which have the possibility of superior investment returns, but also bear the risk of loss.
Annuities and Retirement Planning.
One of the most difficult decisions a person faces in retirement is how much to take out of retirement investment funds so that the funds will last as long as the person lives. The problem is obvious, no one knows how long they will live. Moreover, better medical care, more physical exercise and healthy habits are extending life expectancies. If I live less than I planned, I could have spent more. If I live longer than I planned, I should have spent less. A QLAC which begins paying at age 85 gives the retiree a date certain for the liquidation of retirement funds. If I can make the non-annuity investments last to age 85, then the QLAC payments can take over. The QLAC essentially becomes the second stage of the retirement income rocket.
But if I Die, Don't I Lose All the Money I Used to Buy the Annuity?
It is possible to buy a QLAC which only begins paying at age 85, and if you don't make 85, the annuity company keeps the money. In a purely theoretical sense this makes sense. If I get to age 85, and I need the money, it is there. If I die before age 85, the money is gone, but because I am dead, I don't need it. In this respect the QLAC functions like a pension which ends at death. Some get none, some get less, but everyone reaching the annuity starting date gets paid as long as they are alive. Fortunately though, QLACs are also available with death benefits which mitigate the harsh result of paying the annuity premiums and getting nothing if death occurs before the annuity starting date. As you might expect, if you are guaranteed a death benefit, the annuity company will pay you less than they would if they could keep all your money in the event of death.
QLAC Death Benefits
If the possibility of receiving no payments if you die before the annuity starting date is a problem, e.g., you may have a surviving spouse who needs funds or who hasn't bought a QLAC of his or her own, or you want to leave a legacy for your children or other beneficiaries, then you can choose among a number of death benefits.
- Return of Premium Death Benefit. If you die before the annuity starting date, or if payments have begun and you die, a return of premium death benefit will insure that you (or your beneficiary) will receive payments that equal what you paid for the annuity.
- Survivor Annuity Death Benefits. If you die, an annuity equal to your own will be payable to your spouse, or a lesser annuity to another beneficiary named by you.
How Much of My Retirement Account Can I Use to Buy a QLAC?
While there are favorable aspects to annuities which the government wishes to encourage, nonetheless, the law limits the amount of your retirement assets that can be used to purchase a QLAC. Only the lesser of 25% of the retirement assets or $125,000 can be used to purchase a QLAC. If stock market rates of return are desired for a portion of the retirement assets (as in almost all cases they should be) the desired result can be achieved with the remaining 75% of the retirement funds.
How Much of an Annuity Could I Buy With $125,000 of Retirement Assets?
If a male annuitant, at age 65 (married to a spouse also age 65, where relevant) took $125,000 of retirement assets, and purchased a QLAC which began payments at age 85, the following annual annuities could be purchased:
- Life only annuity, no refund or death benefit: $64,581/year
- Life only annuity, but with a refund of premium benefit: $37,600/year
- Life annuity with a 100% annuity for surviving spouse: $32,198/year
The annuity payment decreases as the possibility of larger or longer payments increases. The life only, no refund, no death benefit is the highest because it is possible that no payments will be made at all. The life and 100% survivor annuity pays the least because the potential benefit payment period is the longest. Note, actual payments will vary among other things depending on (i) the fixed income environment when the annuity is purchased, and (ii) the insurance company's expenses and actuarial factors. The annuities shown are actual quotes, but will vary from time to time.
Who Should Consider Buying a QLAC?
A person who needs all of their retirement funds to meet their retirement needs, should not purchase an annuity where there is a risk that the annuity purchase price could be lost if death occurs before the annuity starting date. That does not necessarily mean that they should never buy an annuity. If such a person does purchase an annuity, the annuity starting date should correspond to their planned retirement date, and if there is a surviving spouse there should generally be a survivor annuity.
The ideal purchaser of a QLAC in its purest form, i.e., one that pays only if the annuity starting date is reached, is someone who can afford to lose the annuity purchase price if they die early. Such a person, if they have a surviving spouse would have enough funds to support the spouse in the event that death occurred before the annuity starting date, or perhaps the spouse would purchase his or her own QLAC. If the annuitant lives significantly longer than his or her actuarial life expectancy, the financial rewards could be significant. More importantly, the extra income could give the non-annuity retirement assets a significant boost which could relieve the economic stress of living longer than expected.
Clearly the QLAC, at least in its purest form, is not for everybody., but for the right person, the one who wins the longevity bet, it could pay handsomely. It can make investing retirement funds more predictable by hedging the unknown longevity risk. The QLAC also serves as a reminder that retirement funds can also be used to provide more traditional annuity payments with more traditional annuity starting dates and survivor annuities which also provide payments for life. Some annuity payments in retirement, ones that are received for life, are generally a good thing. In effect, they become the pension that few people have, but many people want.
This article is written by John T. Bannen, who practices estate planning in the firm's Milwaukee Office. For more information, please contact John T. Bannen at (414) 277-5859 / [email protected], or your local Quarles & Brady attorney.
1 Treas. Reg. §1.401(a)(9)-6, A-12, Q&A-17, §1.403(b)-6, §1.408-8, Q&A-12, §1.408A-6, and §1.6047-2