Executive Summary
The longevity annuity has become increasingly popular in recent years as a potential new vehicle for retirement income, as its ability to delay payments to an advanced age like 85 allows for a significant accumulation of mortality credits. And since the introduction of last year’s Treasury Regulations, a so-called “Qualified Longevity Annuity Contract” (QLAC) can even be purchased inside of an IRA or other retirement account, allowing a portion of a retiree’s RMDs to be deferred from 70 ½ to as late as age 85!
However, as it turns out the unique nature of a longevity annuity’s payment structure is not very hospitable as an RMD deferral strategy. The fact that it can take until a retiree’s late 80s just to break even and recover principal means the retiree risks significant foregone growth by trying to merely defer RMDs through the use of a QLAC. And of course, the RMDs will still eventually happen anyway, as the QLAC merely defers when payments begin. In fact, ironically, if the retiree does live, the accelerated payments of a QLAC in the later years can actually deplete an IRA even faster than normal IRA RMDs would have anyway!
Ultimately, this doesn’t mean that the longevity annuity (or a QLAC inside an IRA) is a bad deal. The ability to accumulate mortality credits still means it can be very effective as a fixed income alternative for those who fear they may not have enough money to fund a retirement well beyond their life expectancy. And if retiree intends to spend all of his/her assets anyway, and the only available dollars for retirement are held in an IRA or other retirement account, the QLAC is an effective means to engage in such a strategy. Nonetheless, the bottom line is that while a QLAC may be a valid way to use a retirement account to hedge against longevity – and defer RMDs along the way – it’s still not very effective as an RMD avoidance or deferral strategy! Just because you can buy a longevity annuity inside a retirement account as a QLAC doesn't mean you should!
What Is A Longevity Annuity (a/k/a the "Deferred Income Annuity" [DIA])?
The basic concept of a longevity annuity is that, like an immediate annuity, a lump sum payment is made in exchange for guaranteed payments (typically for life) in the future. The difference is that while the lifetime payments from an immediate annuity start immediately – as the name implies – with a longevity annuity the onset of those payments is deferred until some point in the future (and thus is also known as a “Deferred Income Annuity” [DIA]).
For instance, a 65-year-old couple today could put $100,000 into a single premium immediate annuity and get (level) payments of almost $6,000/year for life, but if the couple was willing to wait until age 85 to get the first payment, the subsequent payments would be nearly $32,000/year for life instead! The good news of this approach is that the payments in the later years are dramatically larger with a longevity annuity than an immediate annuity. The bad news, of course, is that you have to wait 20 years to get the first check!
Even when adjusting for the waiting period and the time value of money, though, the reality is that in the long run (for those who actually do live a long time), a longevity annuity’s payments provide a better internal rate of return (IRR) than an immediate annuity. In other words, while the longevity annuity buyer is at risk for a greater loss in the early years (since it may take 20 years just to get the first payment!), those greater payments pay off in the long run with a superior implied return (for those who actually live long enough to see them!).
Longevity Annuities, The Required Minimum Distribution (RMD) Rules, And The QLAC
While the trade-off of a longevity annuity may be appealing for retirees, the situation gets more complicated if the only dollars available to purchase such an annuity are inside retirement accounts, like an IRA or a 401(k) plan. The problem is that by its nature, a longevity annuity doesn’t begin payments until a distant point in the future – such as at the advanced age of 85 – and this presents a serious conflict when the standard rules for retirement accounts require that minimum distributions begin beyond age 70 ½! In other words, it’s hard to start taking RMDs at 70 ½ when the longevity annuity payments aren’t even scheduled to begin until nearly 15 years beyond that point!
Technically, it would be possible to still calculate a present value of the expected future longevity annuity payments, in order to calculate what an RMD would be – and then take that RMD from other available retirement account assets, since the IRA aggregation rule does allow RMDs to be taken from any account. But given that longevity annuities typically have no liquidity until the payments begin, if too much is invested into the contract, and/or the other retirement account assets are spent down too quickly, the retiree could still be stuck in a liquidity squeeze where there are no retirement dollars available outside the longevity annuity to cover the next RMD when it is due!
To resolve the issue, last year the Treasury issued new regulations under 1.401(a)(9)-6, declaring that a “Qualified Longevity Annuity Contract” (or “QLAC” for short) could be owned inside of a retirement account, and automatically have its payments (which still might not begin until after age 70 ½) be deemed to satisfy the RMD rules. In order to be a “qualified” longevity annuity eligible to be held inside a retirement account, though, the new rules required that only 25% of retirement accounts can be invested into a QLAC, the cumulative dollar amount invested into QLACs cannot exceed $125,000, the QLAC still cannot defer payments beyond age 85 (i.e., age 85 is the latest possible start date), and the QLAC cannot have a liquid cash surrender value (i.e., it must be irrevocable and illiquid, although it can still have a return-of-premium death benefit payable to heirs).
The establishment of the QLAC rules relieves the need for a retiree to keep other retirement dollars available and liquid to meet any RMD requirements associated with the longevity annuity. Instead, the longevity annuity payments themselves – even if not beginning until age 85 – are automatically deemed to satisfy the retiree’s RMD obligations for the funds in the longevity annuity (so only the other remaining retirement accounts must deal with RMDs, which would come from those accounts). And to limit the potential tax advantages – since the QLAC rules essentially allow someone to defer RMDs from age 70 ½ until age 85! – the Treasury limited both the maximum dollar amount and the percentage of retirement accounts that can be allocated from such retirement accounts into a QLAC.
On the one hand, the issuance of the QLAC regulations meant that retirees who wanted to own a longevity annuity but only had retirement account dollars available now had a means to do so (without worrying about liquidity issues for satisfying RMDs). On the other hand, the QLAC regulations also introduce the potential of using a QLAC specifically as an RMD avoidance (or at least, deferral) strategy. But is a QLAC actually a good way to delay the onset of RMDs?
The Problem With Using A QLAC To Avoid RMD Obligations
While it may appear intuitively appealing to use a QLAC to defer RMDs from age 70 ½ out as late as age 85, there is an important caveat to consider – delaying payments until age 85 also means that the retiree doesn’t get the money back until that point, either! And in fact, even when the payments begin, it takes several years for the payments just to add up to the original principal. Which means the retiree may be deferring RMDs along the way, but in a pure economic sense, must also live until his/her late 80s just to break even and recover the original principal!
And unfortunately, the problem is that’s not even an odds-on bet! For instance, the chart below shows the survival rates (using the Health Annuitant RP-2014 Mortality Tables from the Society of Actuaries) for a 69-year-old single male or single female (i.e., as QLAC purchases from a single person’s IRA will typically be single life, and the buyer would ostensibly make the purchase at age 69 to avoid the onset of RMDs at age 70 ½). Given that the longevity annuity payment beginning at age 85 would be $36,920/year or $32,606 (for males and females, respectively), such that the buyer must survive to roughly age 88 merely to break even, these results reveal that there’s a barely 50% chance that the 69-year-old QLAC buyer even lives long enough to recover his/her principal! In other words, the retiree has to live to or beyond life expectancy just to get enough QLAC payments to get their principal back!
And of course, the reality is that even if a QLAC buyer does live long enough to recover principal, that’s still a significant “loss” in opportunity cost; at an 8% growth rate, an investment would quadruple in value over a comparable roughly-18-year time horizon! So merely getting the principal back after 18 years is not exactly an accomplishment, even if it did allow for RMDs to be deferred along the way.
In fact, the chart below shows the value of a $100,000 QLAC purchase (assuming it has a return-of-principal death benefit guarantee, so its “minimum” value will always be the original starting amount, less taxes), versus the value of a $100,000 retirement account (e.g., a traditional IRA) that simply stays invested at 8%, takes the RMDs as compelled to do so, and reinvests the proceeds in a taxable account. The RMDs are assumed to be taxed at 25% (and in order to evaluate comparable “after-tax” spendable values, any remaining pre-tax value of the QLAC or IRA is also haircut at 25% to ensure an apples-to-apples after-tax-wealth comparison). Growth on the funds already pushed into the taxable account (from RMDs that have occurred, or QLAC payments once they have occurred) are assumed to be taxed at 20% annually, a combination of taxing ordinary income interest and preferential long-term capital gains and qualified dividends.
As the chart reveals, using a QLAC to avoid RMDs is indeed a losing proposition. While the RMD payments may be delayed, the reality is that the QLAC still forces money out of the IRA as well, and in the later years does so even faster than RMDs would have. And in the meantime, the IRR on a QLAC is still "only" about 6% to age 100, while a balanced account can potentially grow closer to 8%, which means the QLAC just lags further and further behind in the initial years. Accordingly, as the chart shows, the retiree must live to age 105 for the QLAC to generate as much wealth as simply keeping the IRA, taking the RMDs, paying the taxes, and reinvesting the proceeds!
On the other hand, for the retiree who 'merely' lives to life expectancy, the loss of using a QLAC to avoid RMDs is dramatic. Even with a return-of-premium death benefit guarantee, at even a healthy retiree life expectancy around age 88 the retiree has merely recovered principal, while the IRA-plus-taxable-account-funded-with-RMDs would be up to more than $300,000 even after taking a haircut for IRA taxes. And in fact, the IRA would still have over $160,000 in the account on a gross basis by then - more than the original $100,000! - which would be available for beneficiaries to stretch, which means the IRA-plus-taxable-account would actually fare even better than the graphic implies (unless Congress eliminates the stretch IRA, of course!)! By contrast, the QLAC buyer will only be leaving behind non-tax-deferred investments in a brokerage account (as any remaining pre-tax payments cease when the QLAC annuitant passes away)! Which means ultimately, while a QLAC does avoid some RMDs in the retiree’s 70s and 80s that the IRA would have triggered, it also forgoes significant growth during that time period, and in the later years the QLAC effectively liquidates the IRA even faster during the retiree’s 90s! In fact, as shown below, the QLAC always leaves behind less of an IRA to stretch than just keeping the IRA and taking the RMDs!
Notably, the inferior result of the QLAC is ultimately driven both by the fact that the level of tax deferral for a QLAC isn't actually that significant (after all, it's not tax avoidance, it's just tax deferral), and that a QLAC simply doesn't have that great of an internal rate of return for those who live to life expectancy, especially when compared to an IRA invested in a balanced portfolio. On the other hand, if the IRA is invested more conservatively as well - such that the QLAC is at least somewhat more competitive on a head-to-head investment basis, thanks to mortality credits - the QLAC fares at least a little better. Still, though, even when the IRA returns are "just" 5%, the QLAC still doesn't pull ahead until the retiree reaches age 93, an age that even amongst healthy retiree annuitants only 20% of 69-year-old males and 29% of 69-year-old females are expected to reach (i.e., it's still not an odds-on bet!).
When A Longevity Annuity Still Makes Sense As A QLAC In A Retirement Account
Notwithstanding the issues with using a QLAC as a means to defer RMDs, it’s not necessarily a bad deal altogether to buy a longevity annuity inside of an IRA (or other retirement account) as a QLAC. If the purpose of the QLAC is specifically for retirement income to spend, and makes sense as a part of the entire retirement income picture, a QLAC is still a reasonable approach (though notably, still inferior to delaying Social Security!).
For instance, as noted previously on this blog, lifetime annuities in general will provide more retirement income than a bond alone over a comparable time horizon, thanks to mortality credits. And as shown earlier, if the goal is to generate strong lifetime payments with big mortality credits, longevity annuities provide an even better internal rate of return in the long run than a traditional single premium immediate annuity. In other words, if the retiree is going to hold fixed-income investments anyway, and wants to hedge against a long life, lifetime immediate annuities are better than bonds, and longevity annuities are better than immediate annuities… and if the available dollars for such a transaction happen to be inside of an IRA, so be it, the longevity annuity will simply be a QLAC. (Notably, though, longevity insurance is far less compelling as an alternative to stocks.)
Similarly, if the reality is that the retiree primarily intends to spend all the available dollars during life, and doesn’t necessarily have legacy goals, there may not be any intention to leave a remaining IRA balance behind… in which case, the fact that a QLAC will accelerate distributions out of the IRA in the retiree’s 90s isn’t a negative but simply a reality of getting the needed cash flows for retirement, and the loss of a stretch IRA for the next generation is a moot point because there isn’t any plan to leave an inherited IRA in the first place!
Ultimately, then, the key point is that if a longevity annuity is appealing to buy for retirement income and longevity hedging purposes - especially as a fixed income alternative - and the available dollars to buy it are within an IRA or other retirement account, there’s nothing wrong with using those retirement dollars and buying a QLAC, and getting the RMD deferral along the way. But if the goal is to defer RMDs in the first place, the value proposition of the QLAC isn’t very compelling, as the retiree takes on a significant risk of losing out on almost two decades’ worth of compounding growth just to defer RMDs, only to find that if he/she lives the QLAC distributions in the client’s 90s will be even more severe than the RMDs ever would have been… and may even be giving up economic growth along the way as well, if the retiree simply could have invested in a balanced portfolio over that multi-decade time horizon!
Great article as always!
Thanks Joe! 🙂
– Michael
Hey Michael;
I enjoy reading your articles and tend to agree with most: however, I have several clients who are still working at 701/2 and making good money so the RMD’s are always subjected to a high tax rate. It seems to me that in this scenario a QLAC for RMD avoidance is pretty valuable if they are at the 28 or 33% tax level and expect to be in a lower bracket at 85 and do not really need this money anyway. Also, some QLAC’s pay a return of principal amount to beneficiaries upon the death of annuitant even after payments have begun if principal has not been depleted. Could also serve as a quasi LTC tool.
I also think using 8% as a return on a retirees investment portfolio is a little optimistic in today,s environment. T achieve this return a retiree would have to be a little further out on the risk curve than they might should be.
Thanks for all of your articles,
David Harrison
David,
Thanks for the comment.
Certainly a tax bracket ‘arbitrage’ between current and future tax rates is always a valid strategy (if the numbers really work out that way). My analysis here didn’t specifically make any assumptions one way or the other about changing tax brackets.
Though notably, if the individual is still working, some/most/all of the retirement account assets may not be subject to RMDs anyway (if eligible for the less-than-5%-owner exclusion), and there’s still a danger that the bigger QLAC distributions (when they show up) could push the client into a higher tax bracket in the future as well.
But all else being equal, yes I’d certainly agree that if the RMDs ARE coming out now and the tax bracket is elevated and will definitely be lower later, there is the potential for value creation there.
– Michael
“the IRR on a QLAC is still “only” about 6% to age 100, while a balanced account can potentially grow closer to 8%.” My understanding is that QLACs are only fixed annuities. How can it be compared fairly to a “balanced” account that grows at 8%? Doesn’t this completely ignore risk? I think any “balanced” account will always outperform any fixed account over a long enough period, but that’s not the point of a fixed annuity guarantee.
Because it’s not about what the investment IS, it’s about what you’re SELLING in order to purchase it.
I’m routinely seeing clients pitched on using a QLAC as an alternative to their diversified portfolio as an RMD avoidance strategy. And the math here shows why that’s a problem.
As i note in the end, IF the investor REALLY was going to liquidate ONLY BONDS WITH LOW RETURNS to purchase the QLAC, yes it’s more competitive. But even in that case, the QLAC is better not because of the RMD deferral, but simply because a QLAC will always beat bonds over a long-term time horizon (for those who survive long enough) thanks to the mortality credits they provide.
– Michael
I concur the 8% is a no-win situation versus QLAC’s in a world of low interest rates. I use 6% only because I know some busted bank convertibles yield that much. The QLAC’s seem attractive only to individuals based on single life with no return of premium to maximize the payment. Those interested have around $2million so that $125,000 is able to be invested “just in case” they live too long and can substitute for long term care. After 70 I reduce the return assumption to 4.5% due to the lack of deferring taxes. In that scenario the non-QLAC runs out around 91-which won’t feel great either and the QLAC keeps plugging. Another twist is I plan on converting my IRA to a ROTH long before I hit 70 so I will QLAC at an earlier age so as not to violate the 25% limit. Thanks for the discussion too.
Your timing is impeccable….We just had this conversation in our office whether we should spend some time getting familiar with these products and whether or not it would be a good fit. Two people thought it was not a good idea for these reasons and one advisor who brought it up thought it could be useful in some circumstances. Like anything sometimes its good to have a tool in the tool box you don’t use very often but your glad its their when you could use it! Thanks for sharing!
What about the idea of using a QLAC in the following manner: during the 15 years from age 70 to age 85, the reduced RMDs made possible by the QLAC allow more “space/breathing room” for Roth conversions (which can be invested relatively aggressively on behalf of the heirs who will hopefully be able to “stretch” them.)
To hedge longevity, one can (1) buy a longevity annuity with after-tax money or (2) buy a QLAC within a 401(k) account. Do you think that buying a QLAC is a better choice? Besides reducing RMD, one could get a better deal because of the negotiation power of a big employer that offers the 401(k). I don’t see any downside of buying a QLAC wholesale rather than buying a comparable longevity annuity retail.
Isaac,
Few QLACs have been offered or sold inside of 401(k) plans as far as I’m aware. To the extent the market is active at all for QLACs, it’s for self-directed IRAs.
It’s also worth noting that within a 401(k) plan, QLACs will likely be based on unisex pricing to avoid non-discrimination issues. This may actually make QLAC pricing WORSE for males purchasing in a 401(k) plan than just buying direct! David Blanchett has noted this as well – see http://corporate.morningstar.com/US/documents/ResearchPapers/Allocating-to-DIAs-in-a-DC-Plan.pdf
– Michael
Thanks Michael. The unisex pricing is important for me to know. You wrote a great article as always.
“In other words, if the retiree is going to hold fixed-income investments anyway, and wants to hedge against a long life, lifetime immediate annuities are better than bonds, and longevity annuities are better than immediate annuities…”
Good analysis Michael. Given the break-even IRR for the DIA vs SPIA being in the late 80s or early 90s for the DIA to catch up to the SPIA (depending on DIA starting payments) and coupled with the behavioral hurdle of not getting any money from the DIA for years or even decades, perhaps the SPIA is still pragmatically best. It is challenging enough to get someone to buy a life-only SPIA, regardless of how the decision is framed. At least with the SPIA, they can get payments right away and reduce the emotional hurdle somewhat.
Perhaps the pricing needs to be improved in the DIA market for this to get any serious traction.
I agree with the assumptions provided. Many retirees are not willing to risk bonds at assumed 5% rates and would rather secure lower returns and not take on the additional risks of bonds. If the retiree is good with 5-8% returns and risk associated then absolutely the QLAC would not be right for them. It would be painful to listen to one of the radio “financial entertainers” try to properly address this subject.
Agreed, to the extent that the retiree was going to hold very-low-return fixed income investments anyway, the QLAC looks far better (at least if they also anticipate living a long time). As I’ve written separately, longevity-based annuity products with mortality credits will always beat bonds over similar past-life-expectancy time horizons, simply because of the mortality credits – see https://www.kitces.com/blog/understanding-the-role-of-mortality-credits-why-immediate-annuities-beat-bond-ladders-for-retirement-income/
That being said, even in those scenarios, the reason to buy the QLAC would simply be for its longevity-hedging benefits and superior IRR at advanced life expectancies over bonds. Still not just as an RMD avoidance tool! 🙂
– Michael
Michael,
Interesting article as usual. Even in the more extreme example of a bond only investor, it would be interesting to see how the QLAC compares with a 15 year zero coupon bond bought at age 70 (assuming that’s today) with the proceeds used at age 85 to buy a SPIA. Granted that it would not avoid the RMDs in the meantime, and you would have to use current assumptions for the SPIA, but it would be interesting to see how much of the mortality credits are passed on to the investor and how much kept by the insurance company. I can’t run an “apples to apples” comparison to your analysis, but I tend to suspect that even at age 100, the QLAC would not show much of an IRR advantage.
David,
You can see an indirect version of how the payments compare just with bonds versus an immediate annuity in this article: https://www.kitces.com/blog/understanding-the-role-of-mortality-credits-why-immediate-annuities-beat-bond-ladders-for-retirement-income/
I did a more in-depth version of this in my newsletter issue on longevity annuities. RMD/tax issues aside, the difference is actually quite substantial in favor of the longevity annuity over just waiting 15 years to buy an immediate annuity in the future. Mortality credits accumulate pretty significantly as retirees get into their late 70s and into their 80s.
I’ll look at doing a standalone follow-up article on this though, as the idea of “what if I wait and just buy it later” is a question I hear often and it has some interesting implications. Stay tuned!
– Michael
Michael,
Thanks. I’ll look forward to your article. I have no doubt that the mortality dividends become significant in the later years, but, call me jaded, I am wondering how much of that is passed on to the investor and how much kept by the carriers. I look forward to your analysis.
Nelson Nash.
I understand that historical returns averaged about 8%, but I do not see how one can assume they will earn an average of 8% going forward. We are in a much lower interest rate environment than we have been in years past, and bonds/bond mutual funds are not earning nearly what they were. Additionally, many retirees/preretirees have become less willing to take on risk. So obtaining an average 8% annual return with low risk tolerance starts to become more difficult. When you factor in sequence of returns risk, the story can change drastically. Early losses for a retiree’s IRA could severely jeopardize their ability to have enough money in their IRA to last the rest of their life. By purchasing a QLAC, you are removing several of these variables and transferring the risk to the insurance company.
Per the article, even at a 5% return, the QLAC buyer would have to live well past life expectancy (which by definition is not an odds-on bet) to come out ahead.
And given the whole nature of the transaction is to buy something that won’t have any withdrawals beginning for 15+ years, sequence of return risk is already ameliorated by the waiting period alone. Even if you retired in 1929 and replicated the spending from a QLAC on top of the Great Depression(!), you STILL had more money in the long run by not buying the QLAC in one of the worst sequence-of-return risk scenarios in history!
The QLAC looks stronger as a pure bond alternative (as noted in the story), but suffers badly against even “bad” equity returns in the long run…
– Michael
For someone who doesn’t want to take their RMD at all, if worst case scenario the annuitant passes away before income starts or before they break even, Congratulations! You’ve managed to avoid depleting that asset, incurring taxable income and the 125k gets to be passed on to the heirs intact.
I agree with Phil below – the reality is that most clients aren’t invested aggressively enough and laying down your “conservative” growth rate at 5% is still very misleading and too generous in many cases. We are talking about a max of 125k – if they have to take off 3.5% from the start in RMDs and continue drawing down, really what will that $125 look like in 10 years anyway? Factor in several down years and you’re absolutely cutting into principal and any significant growth.
For clients whose primary concern is growth, yes obviously annuitization is all about decumulation of assets, so income annuities would not the way to go for them. I believe it’s time for advisors to really learn how to think differently about the decumulation phase of a client’s life where reducing risk and enabling a portion of their assets to generate guaranteed income for themselves and potentially cover a spouse as well is more of a priority than calculating an IRR. Allowing income annuities to do their jobs right will in turn offer clients more confidence investing and spending their assets so they will allow you to be more opportunistic in the areas of their portfolio that are indeed designated for growth.
For those who want to avoid unnecessary taxable income, deferring 125k in income is a huge win. Consider it also as perfect longevity insurance and hedge against running out of income in later years.
Mike,
The $125k payout from the QLAC as a death benefit is still fully taxable to the heirs. You’re not passing it “intact”. You’re passing it fully taxable. All you’ve done is taken a $125k taxable account balance, NOT grown it for however many years, and then passed it on to heirs still fully taxable and without growth.
If the $125k could have been grown even a penny during the intervening time period by not buying the QLAC, you would have been ahead by not buying the QLAC.
All RMDs do is force the same taxable distribution that occurs with the QLAC death benefit anyway. The difference is the RMDs for the money out earlier, but you also get to GROW it during that time period. And deferring taxes on a few percent of the account balance (the RMD) isn’t worth giving up the growth on ALL of the account balance, as the math above showed.
Yes, it’s certainly true that when someone ‘invests’ in a money market earning 0.1%, the QLAC can look better. But that’s still NOT because the QLAC is deferring RMDs. That’s simply because a QLAC has a better internal rate of return than a money market yielding 0.1%…
– Michael
I understand your concerns but you clearly have not had a client tell you that they want 0 increase in taxable current income due to RMDs. In many cases, they are way less concerned about their heirs paying taxes on an inheritance, especially in cases where they’re already leaving behind sizeable assets. Telling them the can defer RMDs on 125k is usually compelling enough that it’s the quickest decision they make and their only dismay is in not being able to put more away.
For those who aren’t as wealthy, the huge payout rate that kicks in once they have this planned to start is incredible and a cheap peace of mind play knowing that if something should blow up the income-generating power of their portfolio, they can still rest assured that they will receive a guaranteed income in the future.
Investors insure their cars, homes, health — most have the majority of their investment assets in retirement money, so why wouldn’t they insure their nest egg? Buying this longevity insurance with 125k and seeing in some cases the break even point be as low as 3 years after income starts is absolutely huge.
I don’t mean to knock you or your math – just saying that advisors who are so focused on accumulation lose their clients to advisors who understand what really matters to retirees. Accumulation advisors get obsessed with IRR, while their clients latch on to – oh this money will last no matter how long I and my spouse live?
For those with large net worth, saving anything in taxes by deferring RMDs is a no-brainer. For the rest of us, insuring our retirement nest eggs is priceless, QLAC or not.
Of course I’ve had many clients tell me they don’t want their taxable income to increase. And then I explain to them that “eliminating all growth from your portfolio to avoid taxable income DECREASES YOUR WEALTH, YOUR INCOME, AND THE AMOUNT YOUR CAN SPEND.”
Frankly, if their goal is to just avoid taxable income by eliminating all growth from their portfolio, they can put their money into a money market, get zero growth, and maintain more liquidity.
I suppose if you obfuscate the fact that putting money into a QLAC will give them LESS wealth than a money market fund (which at least can have a 0.1% return) for the next 15 years it would sound pretty appealing. But that doesn’t actually make it a good deal.
As I noted, more than once in the article, for someone WHO IS OPTIMSTIC ABOUT LIFE EXPECTANCY AND ACTUALLY WANTS TO HEDGE AGAINST LONGEVITY, the QLAC can be quite appealing, especially relative to fixed income alternatives. And once it’s actually economically appealing, there’s value to putting it in an IRA and stacking the tax deferral on top. But that means it’s appealing AS A BOND ALTERNATIVE (supplemented by RMD deferral), not as a standalone RMD avoidance strategy. For the latter, it still has a negative expected outcome for the average consumer compared to just keeping the IRA invested (even ultra-conservatively) and just taking the darn RMDs!
And for the record, I’m hardly an “accumulation” advisor, despite your ad hominem attack to discredit me as such. I’ve published extensively on retirement research (much of which is highlighted on this site), and my first book was “The Annuity Advisor” (http://amzn.to/1NwuHSG) which is still one of the top selling books for advisors on the topic (after 4 editions and more than a decade of updates). And it’s a top selling book in part because we look at the actual underlying facts and mathematical realities of when annuities really DO work, and when they don’t. That aside, I find it ironic that an annuity wholesaler is accusing me of having a biased perspective on this annuity issue. :/
The reason that I analyze this on an IRR basis is not an “accumulation advisor” bias, but simply that any consumer who will BUY a longevity annuity HAS TO SELL AN INVESTMENT TO GET IT. They may be selling a savings account, CD, money market fund, stock, bond, or something else, but the longevity annuity HAS TO BE FUNDED WITH SOME SOURCE OF FUNDS THAT HAD A RETURN. Which is why IRR is a proper way to make an actual apples-to-oranges comparison. Even regulators are increasingly acknowledging the relevance of this source-of-funds issue!
– Michael
We are placing a QLAT for a wealthy conservative 72 year old client of mine tomorrow. She has zero need for her RMD’s, her marginal combined state and federal income tax rate approaches 50%, and, her mother is still alive and receiving care at her age 100. Compared to the bond element within her IRA, and family longevity, it would appear from my analysis, (irrespective of what we may speculative bond returns to average over the course of the next 13 years), that a QLAT is an optimal planning tool for her at this time.
We avoid current high marginal income taxes on the RMD’s, earn a return in excess of comparable aaa rated debt, and, also address her abundantly evident family longevity risk. Truth is, with a $10,000,000 total estate, executing a $125,000 QLAC is akin to a pimple on an elephant’s arse, however we are compelled to implement, because it is the right strategy to execute.
WiseOwl,
If it’s going into the portfolio as a bond substitute for someone who anticipated significant longevity (Mom lived to age 100), the QLAC should look compelling just on its investment merits alone (QLAC vs bonds and the benefit of mortality credits). The RMD deferral should just be a bonus kicker. 🙂
– Michael
Here is a point I haven’t seen discussed. Using a QLAC in effect not only defers the RMD but also helps keep personal income taxes down. If you have over $500k in a retirement acct the RMD will push you into a higher tax bracket and you will incur higher premiums or medicare too. It seems to me that by using a Qlac for 25% of your retirement assets you can effectively reduce your tax burden and potential reduce higher premium for Medicare. If I’m wrong on this tell me how.
Thanks JOE
Because when the QLAC payments actually begin, the situation may become even worse, given the size of the QLAC payments when they kick in. And if you don’t survive long enough to get those payments, you’ll avoid some taxation on your gains by losing all your principal (which is not a plus!).
– Michael
Michael, THanks for your reply. However, If I elect to begin receiving payments at age 76 and Im now 62 plus I have rights of survivorship my wife will receive the payments. If we both die young then our estate receives the principal back because no payments have begun.
Right, and if you pass away that the principal payment will be 100% taxable, all in a single year, because it’s still from a pre-tax IRA.
So in the end, you will have:
1) Taken multi years of RMDs and turned them into 100%-of-principal-in-1-year
2) Given up on ANY growth for 14 years, which at even a conservative growth rate assumption will lose FAR more in growth than you EVER gained in tax-deferral (especially given, per #1, that 100% of the principal is still taxable anyway)
– Michael
No it wouldnt be because I will leave the QLAC in the qualified plan as an asset. Or does it have to come out of the plan to make the investment?
Joe,
The contribution of the qualified plan assets to the QLAC is an IRA rollover. That’s not what makes it taxable. DEATH, and the repayment of the principal in the event of death, is the taxable event.
In other words, your choices are:
1) Take taxable RMDs
2) Take taxable QLAC payments
3) Die without getting payments, and take taxable return-of-principal guarantee
They’re ALL taxable. The only difference is that (2) makes BIG distributions when it occurs (albeit later), and (3) makes the ENTIRE distribution at once. And both (2) and (3) will usually end out with LESS money than just taking (1) with growth, which is exactly what the analysis in this article shows.
– Michael
Interesting Ill check with my account and the read the IRS rules if you’re right then we agree.
JOE
Well you are right Michael. I did more checking and the only way to use a QLAC is through an IRA. PLus you are right that if your QLAC provides for a lump sum in the event of death instead of monthly payments till the remaining principal is exhausted then there would be a large potential tax event. However, if the monthly payment option is elected then it wouldnt be as much. Lots to think about .
ANy other options
Would a QLAC be appropriate to defer a portion of the account and annually convert the remainder to a Roth at a lower tax bracket?
David,
I’d view those as largely independent transactions.
You can convert as much or as little of the Roth as you want, given the client’s tax scenario.
You can also defer RMDs on a portion of the account, or not, given the dynamics as discussed above.
Given that the first RMD is only 3.6% of the account, doing a QLAC for a portion of the account has a fairly trivial impact on that year’s individual RMD (at the most, a QLAC for 25% of the account just reduces 25% of that year’s RMD), and will be trumped by the long-term value of the QLAC (or not).
So do the QLAC if you want to do the QLAC. Convert if you want to convert. Evaluate each on its own merits. (And there are reasons to do both, or not, depending on the circumstances.)
– Michael
I wish this article made sense, but it doesn’t.
(i) All the listed disadvantages, such as dying before collecting anything, are disadvantages of deferred annuities in general, unrelated to whether it is a QLAC and whether reducing RMD is a goal. But the only relevant comparison is between (a) deferred annuities in a QLAC vs (b) deferred annuities not in a QLAC. Of these, (a) is better.
(ii) Of course annuities are bad investments; they are insurance, not investments. if you die, you don’t care that you have lost money. The annuity exists only to hedge against, say, another Great Depression where you lose all your stock market investments but live to be 115. But the value of an annuity is a separate discussion.
You’re missing the point. Similar to previous comments, you’re not taking into account the reality of the situation. Most retirees, hopefully all, who take out a QLAC are doing so to delay RMD’s for the very simple reason that they don’t need the money and don’t want the taxable income.
While the calculations may bear a shed of truth, the numbers you use aren’t realistic.
Try consulting with some practitioners in the industry who are dedicated to helping their clients realize their goals, both short term and long term.
This article uses ACTUAL numbers from available QLACs, and a wide range of growth rates. If you state these numbers “aren’t realistic”, what numbers do you suggest for the multi-decade time horizons involved?
That aside, I understand that the people buying a QLAC to delay RMDs are doing it because they don’t need the money and don’t want the taxable income. THE POINT IS THAT THEY WOULD HAVE MORE MONEY ANYWAY BY TAKING THE MONEY AND PAYING THE TAXABLE INCOME.
If your clients don’t want any taxable income ever, the solution is easy. Put 100% in cash, never invest it, never generate a return, and you’ll never have any growth that is taxed as income. You’ll also have far less money by giving up all your growth. Which is the exact problem being illustrated here for the average person who won’t even live long enough to reach the breakeven if they use a QLAC to delay RMDs.
Again, given that this article uses ACTUAL payouts from QLACs, and a wide range of investment returns… if you claim “the numbers aren’t realistic”, what numbers would you say ARE realistic…?
– Michael
Where is this magical place you can put your money and be guaranteed a safe 8%? It all sounds really good when you have some huge fictitious growth and call it safe. As of today, the last decade has returned us a compound 4.something percent. But you don’t have to believe me, just pull up your iPhone and look at it for yourself. The author is a smart guy but on this, he’s off big time. Finally, he’s just making the age old broker pitch of if you were in a higher rate of return product you would be better off. Problem with that is that retirees shy away from that risk as they get older. We know this to be true because they acknowledge receiving less interest for safety. That’s why a QLAC, aka an annuity, is so appealing to them.
Marc,
This is why the article illustrates comparisons at multiple different rates of return, and provides IRR calculations so you can compare to any rate of return assumption you want. And thus why we finish by explicitly comparing QLACs to multiple investment alternatives with higher and lower returns.
– Michael
I definitely appreciate your view. I think the part that might be missing here is that in insurance we don’t plan for dying at the right time. Your argument kind of says, well they would have to live to be 85 or whatever just to get their money back. While that is correct, we plan for the what if‘s. And sometimes, that “what if” means somebody will pay their premium and just get their money back. And in other scenarios it means that they get a much higher payment/return because the payment is high and they live a long time. Another thing that wasn’t considered in the article is the sequence of returns risk because a “safe” 5% really means junk bonds or riskier positions. Your point is you “could” earn more IF the interest remains level and doesn’t live past a certain point. In fact that could be said of almost any rate above zero. I hope my comment is not taken as disrespectful as I do find you a nice perspective in our industry. I think what most people are saying in this discussion is that the client finds the delay very appealing. Whether that leads to premium in QLACs is another thing. And because they like the delay and are risk adverse (which means much less concerned about rate), a QLAC has a useful place. Therefore, painting it with a broad brush by saying its a “terrible” way to defer RMDs gets us who are out in the field scratching our heads. Finally, is there a different way to “defer” RMDs on an IRA that you know of? If not, then it’s really our only option.
Marc,
If you have a client who is ALREADY willing and able to not take a single withdrawal from this portion of their funds for 15+ years (from prior to age 70 1/2 until age 85) there isn’t much sequence risk involved anymore. Sequence risk is predicated on immediate and ongoing withdrawals – that’s what causes sequence risk. If there are no withdrawals, order of returns is mathematically irrelevant.
But the fact remains the using a QLAC as a strategy to delay RMDs is an odds-on loss for the client. It’s like saying “I have a great strategy to avoid paying capital gains taxes – I just keep all my money in cash so it doesn’t grow.” True, it will avoid capital gains taxes. But it’s more self-destructive than just growing the money and paying the taxes and keeping what’s left over.
For those who find the QLAC genuinely appealing AS an alternative to available investment options, there’s nothing wrong with it at all, as stated here and in other articles on this site about the benefits of mortality credits. If it’s a good investment, it’s a good investment. THEN the fact that it ALSO defers the RMD is a bonus. But buying a QLAC just to avoid RMDs isn’t a good strategy, any more than putting money in a cash is a good strategy to avoid capital gains taxes.
– Michael
So you are assuming aggregation. I missed that when I first read your article.
My apologies for the misunderstanding. In a nut shell, you’re not claiming that the payments would be bad. Nor are you claiming that it isn’t a decent option for higher payments later in life. You’re simply stating that using it just to delay “RMD’s only” doesn’t do much more than just get you your money back based on a normal life expectancy. Therefore, almost any investment would be better.
In other words:
The interest you could earn will be greater than the excess payments above and beyond the deposit on a majority of people.
If that is what you’re saying, then I agree.
I guess this may be true, Marc, but what percentage of people looking at longevity insurance are doing it solely for the RMD deferral and potential aggressive return rates? If I were to decide on a QLAC it would be to mitigate the risk of the rest of my IRA hitting hard times in a time period where not even 5% return is happening. If the rest of my IRA hits a hard time and is staggering after 15 or 20 years it would be good to know a whole new income is coming soon. I would think by far most retirees are thinking about QLACs for this kind of reason. If your retirement portfolio isn’t huge then an insurance contract to transfer downside risk to the carrier could very well mean a lifeline in your 80’s. Bringing up taxes, IRR and legacy issues, that stuff probably is important to only a small percentage of people who would look at something like a QLAC. The example in a comment below is for a person with a $10M estate! RMD issues may come into play there, but its a rounding error in that kind of situation. If your IRA is not huge you have to pull the RMD anyway because that’s what you live on! And trying to ensure your beneficiaries maximum legacy could backfire by making you broke and a financial burden on them late in your life.
I think this issue of the RMD deferral aspects of QLACs is nothing more than a mental exercise. Deferred annuities are not investments and mentioning them is the same breath with words like growth is pointless. They are transfer of risk insurance products and exist outside the conversation of investments. They guarantee you a certain income for life, which no investment can, and they do that in a way outside the realm of the investment portion of a portfolio.
If you have a retirement portfolio of somebody 65 or older and they’re invested aggressively to be chasing am 8% return they could lose significantly more value of the market has a downturn than your implied loss from deferring RMDs inside A QLAC. If they are also restricted by the size of their account and they’re still invested aggressively enough to be chasing that same 8% then their financial advisor is not doing their job correctly. Also, longevity is the #1 greatest risk during retirement. There is a 50% chance of a couple where both parties are age 65 to see at least one of them reach their mid-90s. If they have no pension, there should be at least one product in their portfolio that 1) doesn’t lose value and 2) can provide income for life outside of any benefits received from Social Security.
Michael,
Are there any benefits of a GLAC for estate planning? I will not need my IRA distributions when turn 70, will always be in the top bracket and would like to leave as much as possible to my kids?
Thanks
You guys love to use a hypothetical “8% return” as a club against anything but equities – because you’re equity pushers and it serves your self interest. You ignore volatility and losses, portraying equity returns as if they roll off a predictable 8% – a complete farce which you well know but refuse to say. Even if we ignore volatility, you portray 8% as a reasonable assumption for retirement funds and refuse to point out that many historical periods failed to achieve this high mark and say nothing about the emotional impact of seeing an equity downturn gut your retirement nest egg at age 70.
The reality is that the S&P 500 – a benchmark that most money managers cannot beat over any medium or long term horizon, yielded not 8%, but a painfully volatile 0% over the first 15 years of this century – starting from a high stock market very much like today’s. Equity risk and equity sequence risk are very real concerns for seniors – who have shorter time horizons. For those who have saved and can afford to be conservative, such a choice is quite reasonable here at the top of a long bull run.
As money managers, its your job to remember how many people’s retirements were crushed due to over aggressive equity positions in 1986-88, 2000-2003 or 2007-2009 and to tailor your responses to long term reality, rather than boasting about 8% returns during a bull run.