Deferred Income Annuities as Longevity Insurance

With retirement costs and life expectancies increasing, the biggest concern for many retirees is the possibility of outliving their income. To address that specific concern, Deferred Income Annuities (DIAs) were introduced as a form of “longevity insurance” in 2012. For retirees who want to maximize their future income, while protecting against extended longevity, DIAs provide an effective solution.

How a Deferred Income Annuity Works

A DIA is similar to a Single Premium Immediate Annuity (SPIA) in that it exchanges a lump sum premium for a guaranteed lifetime payout. The difference is, with an SPIA, the payout starts immediately and continues for the lifetime of the annuitant. With a DIA, the payout is deferred until sometime in the future up to 40 years. The DIAs can be especially effective for retirees who have no need for an immediate income stream and anticipate a bigger need for income in the future.

Income annuities such as SPIAs and DIAs are very appealing to retirees who want more certainty in their retirement income. With a SPIA, the investor can target a specific payout amount which can be guaranteed with an appropriate lumpsum premium amount. Or, the investor can know what payout amount to expect based on the amount of the lumpsum premium invested in the contract. The life insurer applies assumptions such as the current interest rate and the investor’s age and life expectancy to determine the payout amount that can be generated by a lumpsum amount; or, it can determine how much of a lumpsum premium is required to generate a certain payout.

The same is true for a DIA in determining what future payout amount the investor can expect. Using the same assumptions, it can determine how much capital will accumulate over the period of time the income is deferred and the payout amount that will be generated when the payout begins. The retiree will know what he or she can count on in the future.

DIA Payout Increases the Longer You Wait

Because the payout amount is based on your life expectancy, the longer you wait to start taking income from a DIA, the higher your monthly payout amount will be. For example, if you deposit $50,000 into a DIA at age 65 with payments to begin in 15 years at age 80, your monthly payout will be about $1,300 a month. If you wait until age 85 to start receiving income, the monthly payout jumps to $2,475. Because the life insurer guarantees your monthly payout for life, you will continue to receive it if you live beyond your life expectancy. That is the real value of longevity insurance.

Planning Considerations for DIAs

DIAs are ideally suited for retirees who expect to live beyond their life expectancy and who don’t have an immediate need for additional income in the early stage of their retirement. They should also have sufficient assets such that the amount invested in a DIA isn’t needed for income or expenses in the near term.  For most DIA contracts, the lumpsum premium deposit is irrevocably retained by the insurer. However, some contracts offer optional riders (for an extra charge), that allow for the principal amount to be refunded to beneficiaries upon your death or for the monthly income to be paid for a guaranteed period.

The payout options vary among different DIA contracts. Some only offer a single life payout, while others may offer other options, such as joint-life, period certain guarantee, or a period certain with cash refund. Because these additional payout options insure more than one life, choosing one will reduce the monthly payout for the annuitant.

A DIA can provide the certainty that you won’t outlive your income, but they should only be considered, along with the guidance of a retirement income specialist, in the context of an overall retirement income strategy.

Using a QLAC to Stretch Your RMDs and Protect Against Longevity

The tax code allows you to defer taxes on your qualified retirement plans until you start taking withdrawals when you retire. As the term “defer” implies, the government intends to collect taxes on your retirement income at some point. To ensure that taxes can’t be deferred forever, it came up with the Required Minimum Distribution (RMD) provision. While it seems reasonable enough on its face, the RMD rule includes a very nasty penalty if it is not followed to the letter. Starting at age 70 1/2, if you fail to withdraw the proper amount, you will be charged a 50 percent penalty on the amount not withdrawn.

The problem for some retirees is the RMD, which is calculated by dividing their qualified plan balance by the remaining years in their distribution period, may be more income than they need. While they can reinvest their excess income from an RMD, they lose a portion of their future income in current taxes. Until recently, there was really no way around this.

How a QLAC Works

The Qualified Longevity Annuity Contract (QLAC) was created for the specific purpose of addressing the risk of longevity – outliving your income. A QLAC provides a guaranteed lifetime income in exchange for a capital investment, except that, instead of paying the income out currently, it is deferred for a period of time, usually about 20 years but no later than age 85.

Until recently, QLACs could only be purchased outside of a qualified retirement plan. That solved one part of the problem – ensuring sufficient lifetime income – but, the RMD problem remained. It was still possible to drain your retirement assets too quickly and, because an investment in a QLAC is irrevocable, it created the potential for a liquidity squeeze if the retirement assets were depleted before the QLAC income kicks in.

That part of the problem was solved recently when the government decided to allow QLACs to be purchased inside a qualified retirement plan. Under this new provision, when a QLAC is purchased using retirement funds, the year-end balance is reduced by the amount invested in the QLAC. The provision limits the amount that can be invested in a qualified plan to 25 percent of the plan’s balance or $125,000, whichever is less. This would then lower your future RMDs by an equivalent amount. The $125,000 cap may be adjusted for inflation.

For example, if, at age 74, you had 23.8 years remaining for distributions (based on the life-expectancy factor in the IRS’s Uniform Lifetime Table), and your IRA balance at the end of 2017 was $400,000, your RMD for 2017 would be $16,807. However, if you used $100,000 of your IRA balance to purchase a QLAC, your fund balance for purposed of calculating your RMD would be $300,000. That would reduce your RMD to $12,605.That reduction of more than $4,000 would continue throughout your life and, when you turn 85, the QLAC will start making guaranteed income payments.* In effect, by purchasing a QLAC inside your retirement account, you are able to defer a portion of your RMDs until age 85.

Planning Considerations for a QLAC

Planning for and protecting against longevity is fraught with uncertainty and the RMD rule doesn’t make it any easier for retirees. Having the ability to reduce your RMD by as much as 25 percent can make a difference for many retirees. However, that should not be your only consideration when purchasing a QLAC. While a QLAC is a way to ensure you have a guaranteed lifetime income stream, it may not be suitable in all situations. Planning with a QLAC can be complicated, which is why it is important to seek guidance from a retirement planning specialist.

*Distributions from a QLAC must start no later than the first day of the month following annuitization, which can be no later than age 85.

The Breakdown

• The Required Minimum Distribution (RMD) provision forces retirees to withdraw a portion of their retirement assets starting at age 70 ½ whether they need the income or not.

• Taking RMDs when the income is not needed, creates an additional tax burden and reduces the availability of assets needed for future income.

• Qualified Longevity Annuity Contracts (QLACs) were developed as “longevity insurance” to protect against the possibility of outliving your income.

• Capital invested in a QLAC is used to generate a guaranteed lifetime income, but the payment period is deferred until a later age (no later than age 85).

• Recently the government allowed QLACs to be purchased inside 401(k) plans and traditional IRAs with the effect of reducing the amount of assets subject to the RMD calculation thus reducing the RMD each year.

• Using a QLAC to reduce RMDs can involve complex planning requiring the guidance of a retirement planning specialist.

Annuities as a Bond Alternative

Bond investors, or investors considering adding bonds to their investment portfolio, are in a pickle. After near three decades of declining bond yields, they’ve hit rock bottom. That’s great if you have been holding bonds during that period because the decrease in bond yields pushed bond prices to record highs. However, with bond yields still hovering near historic lows, there’s only one way they can go – up. When that happens, bond prices will decline. There goes your portfolio stability, which is one of the main reasons for owning bonds.

The other reason for owning bonds is to generate a steady income. With historically low yields, the income from bonds has been meager, forcing many investors to seek out alternatives, such as high-yield bonds, REITs, and dividend-paying stocks, which can introduce more risk into their portfolios. Although signs point to higher bond yields in the future, they can’t come fast enough for yield-starved income investors.

Building a Better Bond Investment

Consider for the moment that you could find a 10-year, investment-grade bond with a 4 percent coupon rate and a principal guarantee. Sound attractive? Most bond investors wouldn’t hesitate to add them to their portfolio and hold them for the entire 10-year period. Unfortunately, such a bond doesn’t exist.  However, a vehicle with very similar characteristics does exist and it’s called a fixed indexed annuity (FIA).

FIAs have experienced strong growth over the last several years, logging record sales in 2015 and 2016 before leveling out in 2017. Their popularity surge has been attributed to the increase in market volatility during that period. Although they offer limited upside, investors have become more concerned about limiting their downside by increasing portfolio stability.

FIAs offer the fixed income component of bonds but without the exposure to interest rate risk. They offer participation in the gains of the stock market without exposure to market declines. Bond-like returns can be earned without risking principal and earnings grow tax deferred.

How a Fixed Indexed Annuity Works

There are two ways to invest in FIAs. A single-premium FIA is a one-time investment, while a flexible-premium FIA allows for smaller, incremental investments over time, which makes it a good alternative for bond fund investors. Investments in both types can be allocated between a fixed account and one or more indexing strategies. The fixed account pays a fixed rate of interest for one or more years that is competitive with CDs of similar duration.

The indexing strategies offer the opportunity to generate returns based on the performance of an underlying stock index, typically the S&P 500 index. Instead of a direct investment in the index, where you experience both gains and the losses, an interest rate is credited to the account based on returns of the index.

If the index’s return is positive, interest is credited to your account subject to a cap. If the index’s return is negative, no interest is credited but the account is credited with a minimum rate guarantee. Each contract year, any gains in the account are locked in.

Advantages and Disadvantage of FIAs as a Bond Alternative

When looking at a fixed indexed annuity as a bond alternative, there are several distinct advantages to consider:

  • Participation in stock market gains
  • Protection from market losses
  • Simplified investment management
  • No credit risk or interest rate risk
  • Tax deferred growth
  • Lifetime income sufficiency with an income rider or minimum guarantee withdrawal benefit

The disadvantages of FIAs should also be considered:

The most notable disadvantage is that FIAs require a long-term commitment. Most FIAs have a surrender period during which any withdrawals that exceed 10 percent of the annuity balance is subject to a surrender charge. The surrender period varies, ranging between five and 10+ years. The surrender charge can start as high as 15 percent but declines each year until it reaches zero, after which there are no more surrender charges.

For long-term investors who don’t need short-term access to their funds or who typically maintain a long-term fixed income allocation in their portfolios, duration should not be a concern.

When investing in any type of annuity, especially when you expect to convert it into a guaranteed lifetime income, the financial quality of the issuing insurance company should be a primary concern. With fixed annuities, the insurance company bears the underlying investment risk, protecting investors from market and default risk. While life insurers have rarely run into financial difficulty, for the greatest peace-of-mind, investors should consider insurers with the highest financial ratings from A.M. Best, Moody’s, and Standard & Poor’s.

Transferring Pension Risk through Buyout and Buy-in Arrangements

Companies seeking to reduce costs continue to offload pension liabilities at a record pace. Pension buyouts swelled to $23 billion in 2017, a 68 percent increase over the prior year. With rising interest rates and lower corporate taxes, an increasing number of companies are seeing their pension funding levels rise enough to make transferring their pension liabilities to an insurance company through terminal funding and other pension risk transfer strategies.

With the liability transferred, the insurance company assumes the risk of future payment obligations. However, the premium cost is prohibitive for companies with low funding levels because they still have to make contributions to close the funding gap while paying annual premiums to the Pension Benefit Guarantee Corp (PBGC). Rising interest rates and lower taxes, companies have been able to close that gap through improved investment performance and higher contributions to the pension plan.

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The Impact of the New Tax Bill on Annuities

The highly anticipated Tax Cuts and Job Act signed into law in December 2018 is the most significant tax legislation enacted since the 1980s. Most taxpayers across the spectrum – both individual and business – come out ahead with the reduction in tax rates, the increase in the standard deduction, and the business income deduction for many small businesses. The tax treatment of investment income from capital gains and dividends is left untouched. The tax advantages of annuities, long considered a target of policymakers as a source of new tax revenue, also escaped unscathed. For now, annuities maintain their tax-favored status and remain a viable investment option and planning tool for many different purposes.

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Sweep the Gains from Equity Positions Into an FIA

For Investors on the glide path to retirement, they have a nine-year bull market to thank for rescuing their retirement plans. In 2017, the surging stock market produced double-digit gains in all sectors except energy, which means, if you were invested in stocks, you did well. For pre-retirees preparing to transition into retirement over the next five to ten years, it may be the perfect opportunity to lock in some gains and protect them to maximize future income.

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Indexed Annuities as a Bond Replacement

In the context of an asset allocation strategy, bonds serve two primary purposes: 1) to provide steady income and 2) to counter the volatility of the equity portion of the portfolio and provide stability. How has that been working for you?

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Using a SPIA to Purchase Life Insurance

If you work with older, high net worth clients, you have most likely uncovered the need for life insurance, either to provide estate liquidity or for the purpose of increasing a family legacy. Whatever the reason, a life insurance policy is a major purchase for older clients, often requiring the payment of large premiums for the remainder of their lives. While you wouldn’t recommend such a purchase for any clients who don’t have the income or the assets to comfortably cover the premium payments, you could greatly enhance the financial position of those who do with the use of a Single Premium Immediate Annuity (SPIA) as a funding source.

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Annuities and Retirement Planning

Retirees’ demand for more predictability and security in their retirement income has led an increasing number of financial advisors to look to annuities as way to provide more stability in their clients’ investment portfolios. They are also looking to annuities as a way to replace the third leg of the retirement income stool as a guaranteed lifetime income. Retirement planning occurs in different phases and at different stages of peoples’ lives. Depending on what stage of life a person is in, there is different kind of annuity that is best suited for their situation.

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Creating a Pension Using a Fixed Indexed Annuity

You’ve probably never heard anyone complain about their pension. That’s because it provides the certainty of knowing how much income they will receive and that it will last as long as they do. That kind of certainty is very difficult to replicate, which is what makes annuities so attractive.

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