Are Longevity Annuities Ready For Prime Time?
April 28, 2015 by Donald Jay Korn
After getting a boost from a federal rule change last year, deferred income annuities have been gaining sharply in both assets and interest. Advisors should now understand what these products can do for clients — and what challenges they carry.
The products are best understood in contrast with traditional immediate annuities, in which consumers give money to an insurer and receive a set amount of cash flow right away. (Read more on those on page 59.) With their deferred counterparts — known as deferred income annuities, or DIAs — consumers wait to receive payments in order to channel a larger income stream.
As a subset of deferred income annuities, longevity annuities may provide a solution to clients worried about running short of money over an extended retirement. Longevity annuities typically don’t start payments until annuitants are in their 70s or 80s; the time from paying premiums to collecting cash flow might be 20 years or longer.
There’s a good sample case on a calculator at immediateannuities.com, a site published by an annuity broker in Princeton, N.J.
A 65-year-old couple might pay $100,000 now for a traditional joint life immediate annuity with a return-of-premium feature (which would give a beneficiary any difference between pay-ins and payouts). In return, they might get around $450 a month — $5,400 a year — if they start to receive payments right away.
But with the deferred option, they could increase that payout to about $10,500 a year by waiting until 75 to start, or to more than $16,000 a year by delaying until age 80. Deferring until age 85 would increase that number further (and the payments could be even higher without the return-of-premium rider).
The actual numbers will vary, but the concept remains: The longer the wait, the more cash clients can receive for the rest of their lives.
“It’s comparable to waiting to start Social Security benefits in order to get larger monthly checks,” says Joe Franklin, an advisor in Hixson, Tenn.
Until last year, longevity annuities and retirement accounts didn’t mix well. After age 70?½, seniors typically must take required minimum distributions; DIA values were included in the asset base, even though no cash flow would come for many years.
Here’s how it worked: If a 72-year-old woman used $100,000 of her $400,000 IRA to buy a longevity annuity, her distributions would be based on that larger $400,000 balance, even though she had only $300,000 to draw upon.
That made them a tough sell to clients who didn’t need the cash and were particularly tax-averse.
But the IRS released final regulations last July for a type of longevity annuity known as a qualifying longevity annuity contract — or QLAC — which can be held in a retirement account, and isn’t subject to required minimum distributions.
Under the new rules, if that same woman now uses $100,000 of her $400,000 IRA to buy one of those qualifying longevity annuities, her distributions would be based on the $300,000 remaining available, not the larger $400,000 balance. (Once the delayed payouts begin, of course, they’ll be fully taxable.)
A longevity annuity must pass several tests to qualify as a QLAC.
While it can offer a return of premiums to heirs, for example, there can’t be a liquidity feature — so the $100,000 that a client puts in will be beyond that client’s reach, other than through the annuity payouts.
Purchases are capped at 25% of the retirement account’s balance or $125,000, whichever is smaller.
And payouts must begin at no later than age 85. The payments “can start earlier than age 85,” says Ben Birken, an advisor at Woodward Financial Advisors in Chapel Hill, N.C. — but, he cautions, “the earlier you start, the lower your payout.”
So do these annuities make sense for some clients? “I think using DIAs in IRAs and 401(k) accounts is an interesting concept,” Birken says. “A great deal of academic work suggests that annuitizing some portion of assets ends up leading to better financial outcomes.”
Franklin says advisors should now recommend them, particularly for those clients who want more certainty about retirement income at advanced ages.
“We have set up deferred income annuities for some clients,” he says. Clients “tend to be very conservative, and they like the idea of a guaranteed increase in the payout by waiting a certain number of years. We’ve had conversations with some of those clients about getting higher income later, if they wait longer.”
The products appeal to clients who want to minimize their RMDs, he adds: “Some of our clients do not like … paying tax on money they don’t need.”
Longevity annuities might be good for those people, Franklin says, because they’ll be able to reduce current required distributions, delay taxable distributions from the annuity and perhaps leave more to beneficiaries.
And unlike variable and indexed annuities, advisors say, these products are simpler and carry lower commissions. The latest report from LIMRA, through 2014, showed DIA sales jumped 22% from 2013. That said, the total was just $2.7 billion, while total annuity sales were $235.8 billion.
Yet there are some drawbacks to the new products. For one thing, Birken points out that it can be difficult to get clients to consider any immediate annuities, let alone deferred annuities, despite the academic studies pointing to better outcomes.
“The idea of irrevocably shelling out a chunk of money is just hard for people to grasp,” Birken says. “Consider how hard it is to convince clients that delaying Social Security is in their long-term interest, if they are concerned about longevity risk.”
What’s more, QLACs tend not to offer inflation adjustment riders, according to Birken. “The limited number that I’ve seen that offer inflation protection only do so once the annuitant actually starts receiving payments,” he notes — so such an annuity may not prove to be a sound investment if inflation “kicks up substantially” between the purchase and annuitization dates.
Michael Kitces, partner and director of research at Pinnacle Advisory Group in Columbia, Md. (and a Financial Planning contributor), is also cautious on QLACs. “The expanded Treasury regulations had new requirements for these products, which required insurers to create them and get them through the state approval process,” he says. “The first QLAC contracts are only just now becoming available.”
For now, however, his firm is not recommending them to clients — in part because their modest internal rates of return detract from their appeal.
“The mere fact that they exist and are legally able to be purchased inside of a retirement account is not a reason to purchase them,” he says. “They need to be financially compelling to the retirement income picture. Given how current products are priced, there doesn’t appear to be a persuasive case yet.”
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.