February 3, 2015
February 3, 2015
Several government agencies are worried about your retirement. So are members of Congress, as well as many economists. Why? With the rapid demise of defined benefit pension (DB) plans (i.e., those that provide a guaranteed monthly income for life), projected inadequate savings by participants in defined contribution plans (DCPs – such as 401(k) plans), and increasing life expectancies, they are all worried that a wave of retirees over the next decades will find themselves living longer, yet running out of money sooner in retirement.
A key solution being proposed, “Longevity Insurance,” is really a deferred or longevity annuity. Here’s what longevity annuities are and why you may be hearing more about a special kind of longevity annuity in the near future.
Annuities have been around in various forms for decades, but in their most basic form they all provide some level of the following guarantee. In return for a premium payment, an insurance company will provide the annuity owner a guaranteed fixed monthly income for life. For example, according to a recent quote listed online, a 65-year-old male who purchases an immediate annuity for $100,000 would receive about $557 per month for life (source: ImmediateAnnuities.com on 1/22/2015). For an extra premium or a lower monthly income payment, the annuity owner also has the option to guarantee this income for a minimum number of years, or for the lifetime of a beneficiary (for example, a spouse) should the annuity owner pre-decease him or her.
Before the prevalence of newer types of retirement savings vehicles such as IRAs and 401(k) plans, annuities were popular as a way to save for retirement because the taxation on any earnings in the annuity is deferred until withdrawn. As IRAs and 401(k)s became more attractive with greater tax incentives (i.e., tax deductions for contributions made), annuity sales for retirement saving dropped off. In addition, annuities were criticized for having high fees, sometimes reaching 2% or more of invested assets annually.
Longevity Annuities (or “Longevity Insurance”)
Longevity annuities are simply annuities that, rather than paying income immediately, defer payment until a later date, such as to age 85 or even later. For example, according to a recent quote listed online, a 65-year-old male who purchases a longevity annuity for $100,000 to begin payments at age 85 would receive about $3,136 per month for life starting in 20 years. Annuities and longevity annuities can provide a solution for those retirees with limited means who are worried about running out of money well before the end of their lifetimes, and who wish to ensure they will continue to receive some income to meet their basic living needs should they live long (say to age 100 or even later).
Someone looking at purchasing an annuity may be concerned about the effects of inflation on the purchasing power of that fixed monthly income, and wish to have monthly payments increase in future years to keep up with the cost of living. He or she may also be concerned about the loss of the premium should he or she pass away before collecting annuity payments of at least as much as was paid in premiums (for a basic annuity, all payments stop and any remaining assets revert to the insurance company when the annuity owner dies). These concerns can be addressed with the addition of riders on the annuity policy, but again, they’re not free. The purchaser must pay for each either with an extra premium or a lower initial monthly income amount.
Annuity purchasers should carefully consider both the financial soundness of the insurance company from which the annuity is issued (after all, the “guaranteed” income for life is only good if the insurance company remains healthy enough to pay it), as well as the loss of access to the premium paid to the insurance company (often, a large lump sum).
An additional caveat for investors considering annuity purchases in today’s environment is that with historically low interest rates that now prevail and with the resulting historically weak returns earned by insurance companies on their investment portfolios (which tend to be bond-heavy), current annuity products also offer historically low monthly income.
One common rule of thumb that had gained wide acceptance in prior years is that an investor shouldn’t purchase an annuity within an IRA or retirement plan account. Why pay high fees to get mediocre returns (historically, compared to diversified stock and bond portfolios) inside accounts that are already tax-deferred and that offer the option of buying higher-return investments for lower cost? Over time, however, financially sound competitors have brought lower-cost annuity products to market that are somewhat more attractive.
In addition, 2014 brought new regulations that created incentives for some individuals to consider buying longevity annuities inside of retirement vehicles, such as IRAs and 401(k) plans. The new longevity annuities for retirement accounts are known as Qualified Longevity Annuity Contracts, or QLACs, and you will likely be hearing more about them from insurance companies and financial service firms in the near future.
QLACs and the new regulations will be featured in our spring newsletter. Stay tuned.