Longevity Annuities

What are Longevity Annuities?

Longevity annuities are a type of deferred fixed annuity. They are specifically designed to provide income guarantees to people who might outlive their savings. These annuities target people approaching retirement. They simplify the process of retirement financial planning by eliminating concerns with a possibly very long lifespan.

Longevity annuities target people in their sixties or early seventies. The typical purchaser plans for a 15 to 25-year accumulation phase followed by a lifetime payout period beginning at age 80 to 85. By dividing the retirement planning horizon into two pieces, retirement to 85 and then 85 until death, it allows a planner to consider a wider range of alternative investment vehicles.

Longevity annuities are always fixed interest rate vehicles. Those about to retire buy these products for the guaranteed payout beginning 15 years or more down the road. Insurance companies offer cost of living riders to protect against inflation. Non-qualified longevity annuities are purchased with after-tax funds. As such, these annuities do not require that an annuitant commence distributions at age 70½.

What are QLACs?

A Qualifying Longevity Annuity Contract (QLAC) is an IRS conforming variation of the longevity annuity. In 2014, the Department of the Treasury developed specifications for QLAC’s. Their goals were to provide a cost-effective investment vehicle for people concerned about outliving their savings and to allow people the comfort of spending money in their early retirement years knowing that income in their later years would be assured.

The IRS intentionally wrote guidelines that limit an insurance company’s ability to get creative. They wanted the policies to be easy for people to understand and compare across providers.

QLAC’s must be funded with pre-tax income taken from a defined contribution plan or a pre-tax IRA. The entire payout amount is taxable income. Premiums paid may not exceed $130,000 per person (adjusted for inflation) or 25% of the source of the funds, whichever is less. Inflation riders are permitted.

The four critical elements of the policy are as follows:

• No withdrawals during the accumulation phase are permitted
• No Required Minimum Distribution (RMD) is necessary until age 85.
• Funds invested in a QLAC reduce the RMD of the funding source. For instance, assume a defined contribution plan (such as a 401K) has $400,000. $100,000 is invested in a QLAC upon retirement. Commencing at age 70½, the RMD is calculated based on the $300,000 balance and not the $400,000 balance.

How Longevity Annuities work

Longevity annuities, and QLAC’s are a type of deferred income annuity. The pooling of interests makes the longevity annuity a cost-effective investment vehicle. Longevity annuities are priced to assume a use-it-or-lose-it outcome. Assume no survivor benefits, return of premium, or other complicating factors existed. Consider the basic longevity annuity that remains. The following numbers are used for example purposes only. They do not reflect actuarially valid numbers.

A cohort of 1,000 people purchases a longevity annuity at age 65. 700 live to age 85 when payouts begin. Most longevity annuities provide some form of reimbursement in the event the policyholder does not live until the payout phase begins. The insurance company accumulates a portion of the accounts of the 300 who died. Even if they return the value of 200 people’s investments, they have 100 accounts worth of revenue to pay the company’s expenses and enhance the interest paid to the remaining 700.

Once the payout phase begins, these 85 and up year olds begin to decline in numbers rather rapidly. By 90, assume 80% of the 700 have passed on. Under use-it-or-lose-it rules, these people received anywhere from one month to 60 months’ worth of payments. At age 90, there are 700-560 or 140 people remaining. The payout calculations guaranteed when they were 65 were based on this declining base of policyholders.

Surviving policyholders benefit from the early expiration of others. This allows the annuity to fulfill its primary mission of guaranteeing income to those in jeopardy of outliving their savings. Due to the policy restrictions and the profile of a typical annuitant, a longevity annuity typically pays out more than a routine accumulation annuity taken at age 65 with distributions commencing at age 85.

Returning to the complicating factors such as survivor benefits and the return of premium features, the Net Present Value (NPV) of these options is the same as the sole policy owner use-it-or-lose-it alternative. Actuaries design the costs of riders and payouts offered for each option such that the NPV of each alternative is approximately the same. The substantial number of annuitants and the history of life expectancies developed over the years allow the insurance companies to price each feature. No single annuitant is advantaged over another in terms of payout per $1,000 invested.

Longevity annuity payouts are not yet tightly clustered about a standard amount per $1,000 invested. These products are still fairly new. Companies have yet to observe the costs and/or cumulative payouts of likely buyers. It is a self-selecting group that purchases products like longevity annuities. It is not yet clear how this self-selecting group will compare, longevity-wise, with the general population. Insurance companies also have differing opinions about the interest rate environment for the coming decades. Insurance companies need to guarantee payments 25 and 35 years from the date of purchase. Each company will have a unique view of the future of interest rates. Finally, as a rule, financially lower rated insurers tend to offer higher payouts as an inducement for prospective annuitants to trade off payout for security.

How Longevity Annuities are sold

Most longevity annuities are sold by retail insurance agents and/or financial planners. To be used effectively, these products require considerable analysis and knowledge on behalf of the planner and the annuitant. The education process can be substantial.

The IRS intended for QLAC’s to be offered by companies to those retiring on a group basis. To date, most companies have passed on accepting the fiduciary responsibility associated with educating retirees and selling these still new products.

Longevity annuities serve one primary purpose – to eliminate the risk of living too long in retirement planning. Those with adequate retirement funds do not need this product. Those with nearly no retirement funds cannot take advantage of this product. For the remaining population, it is a matter of when they will reach retirement age and the alternatives.

Longevity Annuities role in a retirement plan.

Consider the task of a financial planner working with a person or couple approaching retirement age. The list of information needed and concerns to be addressed is daunting.

• How much net worth does the client have? Where is it?
• How much does the client require to live? How much does the client desire to live?
• How healthy is the client? Does the client have a genetic reason to believe that he/she is predisposed to a shorter or longer lifespan than average?
• How astute is the client in investing? Is the client capable of managing a portfolio?
• How risk averse is the client?
• What are the prospects for inflation? What inflation-protected income sources does the client have?
• Does the client have a strong desire to leave money to heirs? Is there someone dependent on the client such as a disabled adult child?
• Can the client be trusted to maintain spending on a budget?
• What provision has the client made for serious health issues and expenses?
• Where does the client live? Are there any state regulations that might enter the planning calculation?

There may be more issues to be addressed. The financial planner must craft a plan covering a planning horizon from 65 (retirement age) to the death of the client or the client and spouse. That is approximately 20 to 35 years. No one knows when they will die. Plan too conservatively, and the client has minimal money to spend while alive leaving a large chunk for the heirs. On the flip side, spend too much too soon and the client runs the risk of spending his/her 90’s in poverty.

Planners solve the problem by dividing the planning period into a near term (65 to 85 years of age) and a long term (85 – death). They develop two distinct strategies, one for the first 20 years, and one that begins in year 21. Longevity annuities clearly fall in the long-term environment. However, they are not the only investment vehicle available for this task.

Having removed the first 20 years of retirement from our planning requirements, the planner is free to focus on maximizing a plan for the client’s 80’s’, ’90s, and perhaps longer. Consider the following:

• Worst case, the client has 20 years to use the capital allocated to 85+ to grow his/her account. Best case, he/she has 30+ years.
• Longevity annuities prohibit withdrawals in the accumulation phase. The only way to receive a partial return is to die before the payout phase begins. In that case, the problem of living too long is mute.
• Longevity annuities are use-it-or-lose-it based. They provide for a spousal option or a return of premium rider, but the NPV of each option is the same. Each policyholder decides how to divide the same sized pie among his/her beneficiaries. All pies are the same size per $1,000 invested.
• In the last 150 years or so, equities have never lost money over a 35 year period. In fact, they have never yielded a return that averaged less than 5.3%. 5.3% represents the estimated return for recently priced longevity annuities based on an at least one person of a couple living to 100 years of age.
• Without the need to take any distributions over the first 20 years, there is no sequence of return risk in investing in equities for the first 20 years.

There are three primary options for investing for a financial need 20+ years down the road. They include:

• A longevity annuity
• A fixed income portfolio
• An equity portfolio

Each has unique risks and benefits. Current interest rates, market conditions, annuity payouts, and tax considerations determine which is the best alternative.

Longevity Annuity – Pros

• No maintenance for the annuitant.
• Enhanced financial return due to the death of other annuity purchasers. Only a longevity annuity can enhance the return via pooling.
• Predictability and stability
• Options to return capital to others and to protect your spouse (though at a cost)
• Most providers allow for a cost of living rider to eliminate the risk of inflation – at the cost of an initial lower payout per $1,000 invested.

Longevity Annuity – Cons

Unless you have paid, in the form of a reduced payout, for a reminder to be paid to an heir when you died the invested money and gains revert to the insurance company.

• Inflexibility – When you sign on the dotted line and make the payment, you are relieved of all responsibility and control of those funds.
• All gains received from payout will be taxed as ordinary income. If the annuity was purchased with pre-tax funds, the entire payout will be taxed at ordinary rates.
• If the insurer runs into financial difficulties, you will have a state guarantee but may not receive all that was promised.

Fixed Income Portfolio – Pros

• Some inflation protection is available in the form of TIPS
• Bonds can be laddered to optimize annual income over a specific time horizon.
• If you pass away during the laddering period, your heirs will collect the remaining assets in your account.
• Liquidity and flexibility – you can sell bonds if necessary or change investment strategies as necessary.

Fixed Income Portfolio -Cons

• At present, interest rates are low. A bond portfolio constructed under current conditions (December 2017) will not grow substantially during the accumulation phase.
• Laddering only works for a finite time. It is possible that a person can outlive a portfolio designed to self-amortize.
• Bonds are among the safest investments, but it is all relative. If one issuer defaults, it is possibly due to economic conditions that will result in other defaults.
• The ability to touch the money during the accumulation phase may be too tempting for some.

Equity Portfolio – Pros

Equities have a nearly 150-year record of growth. It is not a guarantee, but it is a favorable sign.

• Some equities pay dividends. Those dividends tend to increase over time yielding improved returns over time.
• When you pass away, all remaining equities in the account will be distributed to your heirs.
• Capital gains incur lower tax rates. This assumes all securities were purchased with after-tax funds (not a QLAC)
• Flexibility and liquidity – You are not locked into a set portfolio. You can withdraw funds if necessary.

Equity Portfolio – Cons

• Managing an equity portfolio requires knowledge, interest, and time. It can be expensive to hire someone to manage the portfolio for you.
• Random walk suggests that a pattern of 35+ year declines is simply a matter of when and not if. There is no assurance of a specific return.
• The ability to touch the money during the accumulation phase may be too tempting for some.
• The portfolio is vulnerable to the sequence of returns condition. The timing of negative return years, even if offset by good years in other periods, can yield weak overall portfolio returns.

As of December 2017, the NPV of the three alternatives shows that an equity portfolio has the best-expected return for a prospective retiree. The longevity annuity is next best based largely on the return boost provided by the pooling feature. The fixed income portfolio offers the lowest return of the three. Readers are cautioned that any such analysis is subject to assumptions of inflation, economic conditions, and other factors over a 20 to 30 year forecast period. The relative rankings are subject to change over time