Executive Summary
In recent years, a new form of retirement income annuity solution has been gaining visibility: the longevity annuity. A "cousin" to the more familiar immediate annuity, the goal of the longevity annuity is similar - to provide income for life - but the payments do not begin until years (or even decades) after the purchase. As such, these "deferred income annuities" can provide significantly larger payments when they do begin - e.g., at age 85 - in light of both the compounded interest and the mortality credits that would accrue over the intervening time period.
However, a fundamental complication of the longevity annuity is that if retirees want to use retirement account dollars but the payments might not begin until as late as age 85, there is a direct conflict with the required minimum distribution rules that compel payments to begin at age 70 1/2. To address this challenge, the Treasury has issued Treasury Regulations under 1.401(a)(9)-6 that resolve this conflict, declaring that as long as a longevity annuity meets certain requirements, it will be deemed a "Qualified Longevity Annuity Contract" (QLAC) and automatically be deemed to satisfy the RMD rules even though payments don't begin until later.
While the new Treasury Regulations may be a boon to annuity companies that wish to sell longevity annuities, though, it's unclear whether the new rules will real impact anytime soon, for the simple reason that longevity annuity purchases have been growing but still represent barely 1% of all annuity purchases; to say the least, consumers have not been banging down the door to buy such contracts, in their IRAs or otherwise. In fact, given that most consumers are reluctant to buy immediate annuities where they surrender their lump sum liquidity to receive payments for life, it's unclear why they would feel better about a similar contract with payments that don't begin for decades! And in the end, the actual internal rate of return on longevity annuity payments - even for those who live to age 100 - is not necessarily very compelling yet compared to available investments or even delayed Social Security alternatives. Nonetheless, when interest rates eventually rise, and as longevity annuity pricing becomes more competitive, the payout rates for longevity annuities will likely rise as well... and the new Treasury Regulations do at least open the door to longevity annuities inside of retirement accounts if they eventually become more compelling!
What Is A (Qualified) Longevity Annuity Contract (QLAC)?
The longevity annuity – also known in some circles as the Deferred Income Annuity (DIA) – is similar in principle to an immediate annuity, where a lump sum is converted into a lifetime stream of payments. The key distinction, however, is that with a longevity annuity, the payments for life don’t begin immediately. Instead, they start at some point in the future.
For instance, a $100,000 contract purchased by a 65-year-old couple might stipulate that payments will not begin until they reach age 85. However, the couple does reach age 85, payments of $2,656.20 will commence and be payable for as long as either remains alive. Notably, the trade-off here is rather “extreme” – if the couple dies anytime between now and age 85 (assuming both pass away), the $100,000 is lost. However, if they merely live half way through age 88, they will have recovered their entire principal, and from there will continue to receive $31,874.40/year thereafter, a significant payoff for “just” $100,000 today.
Of course, the payout rates will vary depending on the starting age. If the 65-year-old couple begins payments at age 75 instead of 85, the monthly payments are only $934.18/month, instead of $2,656.20. The couple could also purchase a single premium immediate annuity at age 65 with payments that start immediately, but the payouts would only be $478.91/month. Thus, in essence, by introducing a 10-year waiting period, the payments more than double; by waiting 20 years, the payments more than quintuple! And if the couple starts even earlier, the payments are greater; a longevity annuity purchased for $100,000 at age 55 with payments that don’t begin until age 85 receive a whopping $4,054.10/month ($48,649.20/year!) if at least one of them remains alive to receive the payments! Alternatively, the couple could include a return-of-premium death benefit (to the extent the original $100,000 is not recovered in annuity payments, it is paid out at the second death to the beneficiary), which would drop the payments to a still-significant $3,690.30/month. (Quotes are from Cannex, as of 7/8/2014)
In essence, the concept of the longevity annuity is to truly hedge against longevity; while the couple may receive limited payments if they don’t survive, the payments are very significant relative to the starting principal if they do live long enough; in fact, the payments can be so “leveraged” against mortality that the couple doesn’t actually need to set aside very much in their 50s and 60s to fully “hedge” against living beyond age 85 (which also makes it easier to invest for retirement when the time horizon is known and fixed to just cover between now and age 85!).
In theory, a longevity annuity could be purchased with after-tax dollars (a non-qualified annuity), or within a retirement account. After all, the reality is that for many people, the bulk of their retirement savings is currently held within retirement accounts, and if there’s a goal to use a longevity annuity to hedge against long life, those are the dollars to use!
Unfortunately, though, there’s a major problem with holding a longevity annuity inside of a retirement account: how do you have a contract that doesn’t begin payments until age 85 held within an account that has required minimum distributions (RMDs) beginning at age 70 ½!?
Final Treasury Regulations Provide Rules To Coordinate An RMD And A QLAC
To address the fundamental conflict between the structure of a longevity annuity and the RMD rules, the Treasury issued Proposed Regulations 1.401(a)(9)-6 in 2012, and the Regulations were finalized last week. The basic approach of the Regulations is to define a “Qualified” Longevity Annuity Contract (QLAC), and then declare that any longevity annuity that meets the QLAC requirements will not be in conflict with the RMD rules.
To be eligible as a QLAC, a longevity annuity must meet the following requirements:
- Only 25% of any employment retirement plan (or 25% across all pre-tax IRAs aggregated together) can be invested into a QLAC.
- The cumulative dollar amount invested into ALL QLACs across all retirement accounts may NOT exceed the LESSER of $125,000 (original regulations were only $100,000), or the aforementioned 25% threshold. The $125,000 dollar amount will be indexed for inflation, adjusted in $10,000 increments.
- The limitations will apply separately for each spouse with their own retirement accounts.
- The QLAC must begin its payouts by age 85 (or earlier)
- The QLAC must provide fixed payouts (not variable or equity-indexed), though it may have a cost-of-living adjustment (COLA)
- The QLAC cannot have a cash surrender value once purchased (i.e., it must be irrevocable and illiquid), but it can have a return-of-premium death benefit payable to heirs as a lump sum or a stream of income
If the longevity annuity meets the above requirements to be deemed a QLAC, then the value of the QLAC is excluded when calculating RMDs (for other retirement assets), and the payments from the QLAC (whenever they begin) are implicitly assumed to satisfy their RMD obligation (though the QLAC payments will not satisfy RMDs for any other retirement accounts).
Example. Jeremy purchased a $50,000 QLAC at age 65 that will begin payments of $15,937/year at age 85. In addition, he has $400,000 of other IRA assets. By age 70 ½, his IRA has grown to $600,000, and he must begin to take RMDs from the account. His RMDs will be calculated only on the $600,000 account balance, and not include any implied value from the QLAC. Moreover, when Jeremy turns 85 (and we’ll assume his IRA is up to $900,000), he will begin to receive his $15,937/year payments from the QLAC begin, he will still have to take RMDs from his $900,000 IRA (and cannot count any of the $15,937/year QLAC payments towards his IRA’s RMD). The $15,937/year payments from the QLAC itself will automatically (because the QLAC was qualified in the first place) be deemed to meet the RMD rules for that portion of Jeremy’s assets.
Notably, longevity annuities purchased in Roth accounts are not considered QLACs, for the simple reason that Roth IRAs do not have RMDs to comply with in the first place; as a result, an unlimited amount of longevity annuities could be purchased within a Roth IRA (if desired), and the account balances and longevity annuities inside Roth IRAs are not counted towards the $125,000 and 25% limits.
For contracts purchased in traditional retirement accounts (IRAs or employer retirement plans), the dollar and percentage limits do apply. In practice, most investors will be limited to 25% of retirement accounts, as until they have at least $500,000 of retirement accounts the 25% limit will hold (only with accounts greater than $500,000 would the $125,000 dollar limit be the lesser of $125,000-or-25%). On the other hand, each spouse could invest this much into a QLAC, effectively doubling the longevity annuity amount for a couple (if desired).
New Rules Allow You To Buy A QLAC Longevity Annuity In An IRA, But Should You?
While the Qualified Longevity Annuity Contract (QLAC) rules allowing a longevity annuity to be owned inside of a retirement account were essential to avoid running afoul of the RMD rules, the question still arises: a (qualified) longevity annuity can be now purchased inside of a retirement account… but will anyone actually want to?
Thus far, the industry statistics suggest that demand for the products is still weak. In 2012, longevity annuity purchases topped $1B for the first time (averaging $250M per quarter), and in the first quarter of 2014 they’re up to $620M (an annual pace of almost $2.5B). However, the first quarter of 2014 also saw $57.7B of total annuity sales, which means longevity annuities only make up barely more than 1% of all new annuity transactions. By contrast, even single premium immediate annuity purchases were $2.5B in Q1 of 2014, nearly quadruple the pace of longevity annuities. Nonetheless, interest in longevity annuities does seem to be growing, and more companies are throwing their hats into the ring with new products.
At a more basic level, though, the fundamental challenge is that in a world where consumers are often loath to purchase an immediate annuity – ostensibly out of concern for losing their liquidity and their upside potential – it seems even more of a stretch for a longevity annuity to be compelling, with the same problems but no payments until what may be decades from now. Fortunately, the common “what if I get hit by a bus” fear can be mitigated at least, with the purchase of a return-of-premium death benefit, though such guarantees just lower the payments even further. For instance, the 55-year-old who purchases a longevity annuity for $100,000 will get guaranteed payments of $3,690.30/month starting at age 85 with a return-of-premium death benefit along the way. However, if we calculate the actual internal rate of return being generated on the longevity annuity over the time period, the results turn out to be less compelling, as shown below.
As the results reveal, it still takes until age 87 before the couple actually receive back their original principal and begin to generate any actual “return” on their dollars. Even by age 90, the internal rate of return is only 3%, and by age 100 it’s still only 5.3%. While 5.3% certainly isn’t a “bad” return from an annuity company, over a 45-year time horizon it’s still not a very compelling return either, as a combination of both interest rates and mortality credits. Even in today’s low-return environment, long-term corporate bonds pay close to those yields, and the long-term return on equities is highly likely to beat 5.3% over 45 years as well (especially given that no cash flows are assumed for 30 years, which provides a significant barrier to fend off market volatility along the way).
In other words, while it might be nice that a longevity annuity can give a significant payment that's "guaranteed for life" beyond age 85, if its internal rate of return is low enough, the truth is that a simple conservative investment over the same time horizon might have generated even more cash flow over any foreseeable age of death (even with very long life). Similarly, because the internal rates of return are modest, using a QLAC in a retirement account to defer the onset of required minimum distribution (RMD) obligations isn't very effective either. And the reality is that delaying Social Security – which itself is implicitly a longevity annuity – still has a far better implicit payout rate as well compared to today’s commercial longevity annuities, especially given that Social Security is inflation-adjusted while a longevity annuity also runs the risk that unexpected inflation will significantly degrade the purchasing power of its guaranteed income. (Some contracts do provide inflation-adjusted payments starting after age 85, but still require the retiree to "guess" - and risk being wrong - at what inflation will be between today and when payments begin.)
Notwithstanding the not-terribly-compelling implied returns that longevity annuities provide in today's marketplace, the potential remains for longevity annuities to become an increasingly significant part of the retirement income puzzle, especially if/when/as interest rates rise (boosting future payouts), and/or more companies enter the marketplace (potentially making longevity annuity pricing more competitive – i.e., with higher payouts). And for those who do find a longevity annuity compelling, for at least a portion of retirement income… the new QLAC regulations do at least permit investors to own such contracts inside their retirement accounts. And while the dollar amount contributions remain limited, from a practical perspective a retiree would likely only put a portion of funds into a longevity annuity anyway (as they still need to fend for themselves between now and when payouts begin!).
In the end, though, whether prospective retirees will pursue such trade-offs or not remains to be seen, and thus far it appears the "breakthrough" of the Qualified Longevity Annuity Contract (QLAC) regulations is more about permitting insurance companies to sell longevity annuities inside of retirement accounts than consumers demanding to do so, especially once guaranteed payouts are converted into the equivalent not-terribly-high return they're providing over the ultra-long time horizon. Nonetheless, if guaranteed future payouts get higher in the coming years as rates rise and the marketplace heats up, longevity annuities might get a whole lot more interesting.
