Annuity purveyors, as well as annuity buyers, have a life, and they may be excused for feeling criminalized by the federal government these days. The Department of Labor, after all, has made it harder for those selling variable and fixed indexed annuities to IRA owners to accept commissions. Slower sales have been predicted in 2017 for both of these products.
On the other hand, there’s one income-generating annuity whose usage the feds actively encourage: the qualified longevity annuity contract, or QLAC. It lets retirees buy an income annuity at say, age 65, with up to a quarter of their IRA, up to $125,000, and defer income — and the federal tax on that income — until as late as age 85 without violating the rules that require IRA withdrawals to begin at age 70½.
You may be thinking: This deferred income annuity already has three strikes against it. 1) As a simple spread product, it’s not profitable enough for publicly held insurers. 2) By reducing assets under management, it reduces the income of fee-based advisors. And 3), because of its illiquidity, it’s not even popular with retirees. Indeed, few people probably know a QLAC exists.
But QLACs have a couple of admirable, and timely, characteristics. Except for clients who have too little money or are in poor health, QLACs are likely to be in a retiree’s “best interest,” and therefore compliant with the new DOL rule. And, as academics have been saying for several years, they allow retirees to spend their non-annuitized money a little more freely.
To understand the logic of QLACs, consider some points in a new academic paper from the National Bureau of Economic Research. It demonstrates that longevity insurance, as QLACs are also known, can, when used strategically, almost pay for itself.
The three economist-authors, who have studied the use of QLACs in Germany and Singapore, where retirees are required to purchase them with part of their tax-deferred savings, described two hypothetical college-educated women. One bought a QLAC with 15% of her qualified savings at retirement and one did not.
They found that the woman with the QLAC could afford to save a bit less before retirement, spend between 5% and 20% more during retirement, and probably have much more spending power after age 85 than the person without access to a QLAC.
Raimond Maurer, a German professor, in an email exchange, also offered a hypothetical example of a single man with a $120,000 IRA. Under the QLAC rules, he could allocate $30,000 at age 65 to a life-only QLAC paying about $1,200 per month starting at age 85.
Alternately, the same man, seeking the same level of longevity risk protection, could wait until age 85 to buy an immediate annuity. But a life-only annuity paying $1,200 per month for life, purchased at that age, would cost $100,000. At minimum, the man would have to create a side fund of about $55,000 at age 65 to accumulate $100,000 by age 85, assuming a 3% growth rate.
In short, the QLAC gives this hypothetical client $25,000 more spending power in retirement (by spending $30,000 on an annuity at age 65 instead of putting $55,000 in a side or “granny” fund). While $25,000 over 20 years might not sound like much, it’s enough to finance a fair amount of vacation travel during the so-called “go-go” years (ages 65 to 75). Counter-intuitively, the longevity insurance gives the retiree more liquidity in retirement rather than less.
QLACs have another big advantage that isn’t mentioned in the new paper. By reducing a retiree’s longevity risk, these contracts arguably create more capacity for taking on equity risk with non-annuitized assets. Owning more stocks can protect clients against inflation risk and arguably raises the likelihood of producing a larger legacy.
To be sure, the pros and cons of longevity insurance have been known for some time. But what’s new are the Treasury Department’s exemption of QLACs from RMDs at age 70½ and the DOL’s “best interest” requirement for retirement advisors. The bottom line: Allocating part of your IRA to longevity insurance, particularly a QLAC, is probably a smart move.
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