The deferred income annuity (also called the “longevity annuity”) is a relatively new type of annuity contract, different from both the deferred and immediate types.

Like an immediate annuity, it provides only a guaranteed stream of income for life or a certain period of time (or both) and typically has no account balance that may be accessed other than by annuitization.

However, where income payout from an immediate annuity must commence within one year of purchase, the payout from a longevity annuity is generally not available until the annuity starting date chosen by the buyer, which may be many years after purchase.

A typical version paying a stated income for life might specify that payments will not begin until the annuitant reaches the annuity starting age (usually an advanced age, often age eighty-five).

If the annuitant dies before reaching the annuity starting date, the contract terminates without value.

If the annuitant dies after reaching the annuity starting date, the payments may stop immediately (if payments are purely life contingent), or may continue for some fixed period of time (if the annuity has a period certain payment feature).

What about inflation?

Until recently, few deferred income annuity contracts offered inflation protection. Currently, several carriers offer the option of level annual income payments or annually increasing payments.

Typically, the amount of annual increase is chosen at the time of application and is a set percentage increase annually (usually, no more than 6 percent), but a few carriers offer annual increases tied to an external index, such as the Consumer Price Index (CPI).

Notably, though, such increases generally do not apply until payments actually begin at the annuity starting date, such that there is no inflation protection during the waiting/deferral period.

As these contracts typically are purchased decades before the annuity starting date, that can mean that the purchaser of a DIA even with a COLA “rider” may find her income devastated by the impact of inflation during that waiting period.

For clients concerned about the impact of inflation, the authors suggest purchasing the contract in an amount equal to the desired future income compounded at an assumed rate of inflation for the deferral period.

Using DIAs as qualified longevity annuity contracts (QLACs)

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.

The problem is that by its nature, a longevity annuity doesn’t begin payments until a distant point in the future, and this presents a serious conflict when the standard rules for retirement accounts are that required minimum distributions must begin at age seventy and a half!

Or viewed another way, it may be impossible to start taking RMDs at seventy and a half if all the money is tied up in a longevity annuity with payments that aren’t even scheduled to begin until years beyond that point.

To resolve the issue in 2014 the Treasury issued new regulations under 1.401(a)(9)-6, declaring that a “Qualified Longevity Annuity Contract” (QLAC) could be owned inside of a retirement account, and automatically have its payments (which still might not begin until after age seventy and a half) 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 the following:

(1) only 25 percent of retirement accounts can be invested into a QLAC;

(2) the cumulative dollar amount invested into QLACs cannot exceed $125,000

(3) the QLAC still cannot defer payments beyond age eighty-five (i.e., age eighty-five is the latest possible start date); and

(4) 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 eighty-five—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 seventy and a half until age eighty-five—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 seventy and a half out as late as age eighty-five, there is an important caveat to consider—delaying payments until age eighty-five 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 eighties 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 monthly longevity annuity payment beginning at age eighty-five for a $100,000 premium would be $3,404 or $2,812 (for males and females, respectively), such that the buyer must survive to almost age eighty-eight (in both cases) just to break even and recover that premium.

However, based on the Healthy Annuitant RP-2014 Mortality Tables from the Society of Actuaries, there’s a less than 50 percent chance that a sixty-nine-year-old QLAC buyer will actually live long enough (to age eighty-eight) to recover his/her principal. (This assumes that the QLAC buyer purchased at age sixty-nine, shortly before the age seventy and a half RMDs were to begin.)

It’s also notable that if the retiree actually does live past the break-even age, the size of QLAC payments in the later years may actually be larger than what the retiree’s RMDs would have been if payments had been taken along the way.

This creates at least some risk that the use of a QLAC, and concentrating payments in the later years, will actually increase the retiree’s tax burden, by driving him/her into higher tax brackets (albeit after having obtained some tax deferral along the way).

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 leveraging the potential for mortality credits makes sense as a part of the entire retirement income picture, a QLAC is still a reasonable approach.

And if the contract happens to be purchased in an IRA, which also provided some RMD tax deferral on top of the appealing potential for mortality credits, so much the better.

However, if the goal is to defer RMDs in the first place, the value proposition of the QLAC on its own isn’t very compelling.

That’s because 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 nineties 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 multidecade time horizon.

Instant Insights /

What you need to know about deferred income annuities, QLACs & RMDs

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