The Long And Short Of It
Americans are living longer than ever before. And to make sure their retirement income goes the distance, they’ve turned to a number of alternatives, including one whose entire reason for being is to solve this problem: the longevity annuity.
A type of deferred-income annuity—as opposed to an immediate annuity—the longevity annuity was developed more than a decade ago to help retirees hedge against outliving their savings and retirement income. Also called “advanced life delayed annuities,” longevity annuities are typically purchased by retirees when they are about 65, on the brink of retirement, for a guaranteed payout 15 or 20 years later.
Yet to date, these vehicles make up only about 2% of the $58 billion annuity industry, as measured by Limra, the trade association. That may be about to change, however, and advisors had better pay attention.
Longevity annuities were created to supplement, not replace, retirement income. The income is guaranteed (assuming the issuing company remains solvent), regardless of market conditions. It doesn’t change with inflation, either, unless the owner purchases a separate inflation-protection rider.
Usually clients invest only a small portion of retirement savings in a longevity annuity—no more than 25% of assets, and some say even less. The earlier the annuity is purchased, the cheaper it is—and the later the payments start, the larger the amount of each payment.
“The value of a deferred-income annuity is the longevity protection, and longevity annuities really leverage this protection by skipping all the intermediate payments and starting income late in the process,” says Wade Pfau, professor of retirement income at the American College in Bryn Mawr, Pa. “Longevity protection can therefore be obtained at a much lower overall cost.”
These annuities gained another advantage last July when the U.S. Treasury Department ruled that they could be excluded from required minimum distribution calculations if they are held within a 401(k) or IRA. All retirees, of course, must begin withdrawing a minimum amount on April 1 of the year after they turn 70 1/2, and that minimum is based on the account balance at the end of the preceding calendar year divided by a corresponding value in the IRS’s Uniform Lifetime Table.
But going forward, up to one-quarter of the account balance, to a maximum of $125,000, can be held in what’s called a qualified longevity annuity contract (QLAC) and removed from the required minimum distribution equation. So if a client has $400,000 in an IRA, he or she can move $100,000 into a QLAC and then, after age 70.5, calculate the required minimum distribution from the remaining $300,000. This reduces the size of the RMD and the concomitant taxes (distributions are taxed as regular income), thus allowing the client to preserve more money in the tax-deferred account for longer than was previously permissible, up to age 85.
“This will have a tremendous impact on the market,” says Victoria Chase Ferren, director of financial planning at Sage Rutty & Co. in Rochester, N.Y. “Retirees’ primary concern now, even above death, is running out of money. As more and more people are living longer and pension availability is rapidly declining, people are faced with fewer options on how to guarantee they will always have an income stream.”
Stan Haithcock, the Ponte Vedra Beach, Fla.-based expert known as “Stan The Annuity Man,” who recently published a booklet on the subject, puts it this way: “The QLAC is a game changer. Within five years, QLACs will be the No. 1 owned annuity type in the country.”
A Difference That Makes No Difference?
Other annuity experts, however, are not so certain. “Although this opens up substantial sums of money to QLACs, I do not believe it will have a significant impact on the market,” says Joseph Heider, president of Cirrus Wealth Management, in Cleveland. “This type of annuity, in my opinion, will remain a niche product for special situations.”
The primary problem, he says, is the “inflexibility.” “The majority of people are concerned about their current needs [and] tend to spend more money early in retirement,” says Heider. In other words, retirees typically want to spend, not save.
That alone could be a deal breaker. “Individuals with large retirement assets might consider using QLACs, but this is a tough sell because these annuity contracts force investors to tie up their assets well into their 80s,” says John M. West III, COO and advisor at Spraker Wealth Management, a fee-only financial planner and wealth-management firm in Maitland, Fla. “As with any annuity, there are normally stiff penalties associated with unwinding the annuity contract.”
What about the tax benefits of reducing the required minimum distribution? “I’m not sure it’s all that compelling,” argues Michael Kitces, a partner and director of research at Pinnacle Advisory Group in Columbia, Md. “After all, you’re not avoiding the taxes—you’re just deferring them. It’s just whether you pay at 70.5 or at 85. So at best you get to keep your tax dollars a little extra time before having to pay the bill.”
That’s a small benefit, he says, especially considering the disadvantages of not investing those funds in equities over the same time period. “At a reasonable rate of return, your money should grow to at least twice its original value after 15 or 20 years, but you’ve given up most of that just to push your taxes down the road,” says Kitces.
The low payout rate is a key concern. “If you put in $100,000 and in a couple decades you get $30,000 a year, that may sound like a 30% payout. But when you actually calculate the internal return rate, or IRR, you find you’re really getting more like 4.5% or 5.5%,” says Kitces.
That might improve, if interest rates rise or a surge in demand causes greater competition among insurance companies. Yet until the IRR grows to more than 6%, Kitces says he would be hard-pressed to recommend them. “Over a 20- or 30-year period, the stock market has never paid worse than what longevity annuities are getting now,” he stresses. “The worst-case scenario for stocks is still better than the best-case scenario for longevity annuities at the moment.”
Giving up some upside in exchange for the certainty of a guaranteed income stream—that is, in exchange for less downside—may appeal to the risk-averse. But others point out that there are alternative methods for guaranteeing modest income and reducing risk. “Short-term ladder CDs will provide that guaranteed income at a much lower price, and as rates rise so will the yields on CDs,” says West.
Such misgivings have validity, but they may not tell the whole story. “The reason longevity annuities haven’t caught on is because the commission to agents is low,” says Haithcock. “They don’t push it and probably never will. However, the consumers are going to drive this train and demand the product because they will easily understand the value proposition.”
The certainty, clarity and dependability are perhaps the most appealing features. “Anyone looking for guaranteed income—i.e., target date income planning—in the future should consider longevity annuities,” says Haithcock. “This is truly a product that is designed for the masses—easy to understand, no annual fees, contractual guarantees [and] fully customizable.”
Once clients become familiar with them in their retirement accounts, he says, they may choose to buy them “in their non-qualified accounts, too, because the strategy is accessible and efficient.”
Brokers need to show clients exactly what they can expect from these contractual guarantees, both with and without riders for cost-of-living adjustments, return-of-premium death benefits, and so forth, he says. “That’s the beauty of longevity annuities. They are fully customizable [for example, in duration and benefit riders], and the agent cannot juice the numbers. Clients know from the start exactly what they are getting.”
Will the public get the message? Reactions are mixed. “I don’t foresee an imminent explosion in the sale of longevity annuities,” says Jeffrey Levine, IRA technical consultant with Ed Slott and Co., in Rockville Centre, N.Y. Yet he allows they’re likely to “become more popular in the coming years.”
Levine notes that the aging population may push demand. “The baby boomer market will continue to retire in record numbers [and] that will in and of itself drive sales,” he says.
At present, there are fewer than 15 companies offering longevity annuities, according to Haithcock. “Only the big carriers play,” he says. The top 10 are: New York Life, Guardian, Pacific Life, Lincoln, MetLife, Principal, Mass Mutual, Northwest Mutual, Symetra and American General.
Yet more may be on the way. “As traditional defined benefit pension plans disappear and the future of Social Security is questioned, individuals are becoming more and more responsible for their own retirement income,” says Elizabeth Forget, an executive vice president at MetLife in Charlotte, N.C., who is responsible for the retail retirement and wealth management businesses. “The ability to have a portion of one’s assets allocated to guaranteed lifetime income, a personal pension of sorts, provides individuals with confidence and certainty that they are building a consistent income stream for their retirement.”
Much of current retirement savings is already “within qualified accounts,” she adds. Optional riders, though they cut into the payout, make this product category even more attractive to a broader segment of the market, she says.
New options are always being added, too. MetLife, for instance, recently launched a “Cash Out” option for deferred-income annuities that allows clients to “get back most or all of their investment before income begins, should their needs change,” says Forget.
It doesn’t come without an additional charge, but that’s just the kind of feature that may soon cause the longevity annuity market to take off.