At a recent Retirement Income Industry Association conference, I asked an insurance industry executive whether longevity annuities have gotten more popular.
“Deferred annuities are doing great!” She paused. “But the only people buying longevity annuities are actuaries, engineers and college professors.”
Unfortunately, these are not the people who are actually selling the annuities or putting them in 401(k) plans. But they are the types that you might want to avoid making eye contact with at a party lest you end up getting stuck talking about stochastic mortality risk.
If one of them did manage to corner you, they would explain that retirees in a defined contribution world won't have a pension to pay them income until they die. They’ll have to decide how much to pull out of their retirement plans each year to cover living expenses in retirement. This means either counting pennies to avoid running out of money, or accepting the possibility that they may have to live off Social Security if they beat the longevity odds.
The other option is for retirees to just pool their assets together to fund late-life spending. The ones that die early drop out of the pool. They lose the money they invested, but they’re dead so they shouldn't really care (although their heirs might). The ones who live the longest start drawing income from the pool later in life, say at age 85, and get the income as long as they live.
This is the efficient way to deal with the so-called idiosyncratic risk of longevity that every retiree faces. It's also one of the biggest flaws in the current defined contribution (DC) system. Most retirees today don't annuitize any of their 401(k) assets, which means they implicitly accept the risk that they’re going to outlive their savings. If the purpose of spending nearly $200 billion of foregone taxes each year on 401(k)s and IRAs is to enhance later-life financial security, then we should care a lot about whether retirees are at risk if they live too long.
Smarter than a 5th grader?
There are a lot of very smart people in Washington trying to figure out how to increase the use of financial instruments that protect against longevity risk in DC plans. The biggest problem, of course, is that most DC plans do not contain investment options that annuitize after retirement. A retiree may, of course, choose to roll their IRA into an annuity after leaving their employer. But most retirees don't do it.
The Treasury Department's Mark Iwry is at the forefront of policymakers in Washington (but is certainly not the only one) looking for ways to tweak regulation to nudge the DC system toward better outcomes for workers. Iwry, who is generally regarded as a retirement policy savant, was instrumental in bringing economic research on the importance of automatic investments into DC plans through the 2006 Pension Protection Act.
The idea was that most workers don't know much about investing and never make it to the benefits office to initiate a 401(k). So why not just give employers an incentive to make employees opt out of retirement plans and then place them automatically in diversified investments that rebalance automatically over time.
Giving plan sponsors added legal protection to include these life-cycle funds as qualified default investment alternatives (QDIAs) has had a remarkable impact on portfolio quality and average retirement account balances. The success of QDIAs can be traced to these two powerful features—giving carrots to plan sponsors to improve investment offerings and relying on the power of defaults to guide the investment selection of workers.
Now that workers are saving more and investing better, Iwry has spent the last few years focusing on improving the decumulation options within DC plans. That means getting more plan sponsors to include annuity products in their plans, and getting more workers to choose an annuity. New regulations and guidance by the Treasury provide a roadmap into the future of decumulation products in qualified accounts that pool longevity risk through annuities and give plan sponsors an incentive to offer them.
In 2012, the Treasury Department and the IRS issued notice of proposed rulemaking on a major barrier to the use of longevity annuities. According to IRS rules, a retiree who wanted to use qualified retirement savings to buy a longevity annuity still had to take required minimum distributions based on the cost of the annuity. Pay $100,000 to buy a longevity annuity and you had to take an RMD from the rest of your retirement savings that was based on this amount. This meant retirees would be required to pull money out of their account to cover RMDs on an investment that never paid a cent until age 80 or 85. For obvious reasons, nobody used their qualified money to buy longevity insurance.
The proposed 2012 rule would allow retirees to forget about paying RMDs on a portion of their retirement savings if they bought a longevity annuity. The IRS bulletin gave the example of a 70-year old retiree who paid $100,000 to buy an annuity that began making payments at age 85 and provided an “annual income that is estimated to range between $26,000 and $42,000” using estimates from the 2000 mortality table.
This past July, the Treasury finally provided the details of regulation that would allow retirees to buy longevity annuities without having to pay RMDs. A qualified longevity annuity contract (QLAC) can skirt RMDs if the cost of the annuity is no more than $125,000 or 25 percent of all qualified retirement savings. If retirees invest $125,000 they can still elect to have their premium returned to their estate if they die before the annuity kicks in (but, of course, this will reduce the income later in life). The QLACs can't have a stated cash value or include subaccounts, but they can be inflation protected.
The psychology of QLACs
Is this regulation valuable to retirees? It is for two reasons. The first is that forcing retirees to increase their taxable income without receiving any actual increase in cash flow was a major psychological barrier to the purchase of longevity annuities. The second benefit, and one that hasn't received much attention among advisors, is the benefit of an additional 15 years of tax-deferred investment.
The payment on deferred annuities is based on expected investment returns at the time a retiree initiates the contract. An insurer will price a conventional QLAC based on long-duration bond rates for cash flows that will occur more than a decade in the future. Retirees could have just invested in bonds to fund later life income, but they will have to pull RMDs out of their bond portfolio between ages 70½ and 85. If the purpose of this money was to fund future spending, then the retirees will pay income tax and invest the remainder. Or they can put the money in the QLAC and gain an additional 15 years of tax deferral. They’ll also get the mortality pooling benefit of an annuity that gives them a higher expected income each year (and an income that will last forever).
How big of a benefit is the tax deferral gain from placing safe retirement investments in a QLAC versus keeping them invested in bonds in a 401(k)? As always, a higher rate of return and a higher income tax bracket will mean a greater benefit from tax deferral. I asked a very patient David Blanchett, head of retirement research at Morningstar Investment Management, to help me calculate the deferral benefit of a QLAC. At a 36 percent tax rate, you’d save about $15,000 in taxes by avoiding RMDs at a 6 percent nominal bond return, and this would fall to just under $14,000 at a 28 percent tax rate.
The deferral bonus isn't huge, but University of Illinois finance professor Jeff Brown has calculated that annuitization can provide as much as a 50 percent increase in expected retiree welfare. The improvement happens because of the previously mentioned idiosyncratic mortality risk protection. Instead of either spending less to avoid running out of money, or spending more and possibly going broke, retirees can pool the risk of not knowing when they’ll die with other retirees efficiently through a QLAC.
The Great Promise
The great promise with QLACs is that they’re designed to preserve the majority (at least 75 percent) of retirement assets in traditional investments assuming the retiree doesn't buy an immediate annuity. Since many retirees become focused on the “number” that appears on their statement balances, it's hard to get them to give up a big chunk of it for the promise of a small monthly payment. It might be easier to convince them to give up a little chunk today for the promise of a bigger monthly payment in the future.
Jeff Brown sees this as the most promising feature of the QLAC since they “feel more like insurance than an investment.” Framing the QLAC as insurance against running out of money later in life can help an advisor sell a client on the importance of setting aside a portion of retirement assets to buy a longevity annuity. “You’re insuring the catastrophic stuff first, and it gives you so much more flexibility,” says Brown. “I think these things have a lot of promise rationally and behaviorally.”
One important problem that will impact the popularity of QLACs is pricing. Remember the actuaries and professors who are the only ones buying longevity annuities today? Another reason the eggheads tend not to be the life of the party is that they’re nursing a prudent class of red wine and avoiding the fried cheese sticks. That means they’re going to live longer than everyone else, on average, and insurance companies will have to charge more to avoid losing money on products that only the healthiest Americans buy.
The limited popularity has a negative impact on pricing, and many insurance companies have been hesitant to devote significant resources to marketing a product that has never really caught on with the public. Until more cheese-stick eaters buy longevity annuities, they’re not going to be a great deal for average Americans.
Following the July QLAC regulation, last October the Treasury Department and the Department of Labor (DOL) issued guidance to help get more longevity annuities into retirement accounts. Remember why the Pension Protection Act of 2006 was so successful? It used two powerful tools to get retirees saving more and putting their savings into better investments—protection for plan sponsors and defaults for employees. The new guidance lays the groundwork for using these tools to get more retirees invested in longevity annuities.
The tsunami of new money in life-cycle (or target-date) retirement funds means that many baby boomers approaching retirement already have their nest egg tied up in an automatic investment. Although we are the land of the free, most workers like not having to worry about managing these assets. Decumulation is an even harder math problem than figuring out how much to save for retirement.
What if a portion of these automatic investments shifted into a QLAC? This would provide longevity protection, and defaulting employees into a longevity annuity would add more cheese-stick eaters into the mix—lowering the cost for the average worker. Plan sponsors could shop around among annuity providers to pick the best products for employees. The new guidance lays the groundwork for moving toward default late-life annuities.
The guidance from the DOL and the Treasury has got a number of progressive plan sponsors excited about the prospect of giving employees access to annuity products. Kevin Hanney, director of portfolio investments at United Technologies, has been an industry leader in pushing the movement toward a lifetime income strategy within DC accounts. To Hanney, the new guidance reinforces his beliefs about the importance of including annuities as an essential component of retirement security that a fiduciary needs to provide for employees.
Both Hanney and Jeff Brown believe that the new guidance was the spark that plan providers needed to begin offering more creative decumulation options within retirement plans. Hanney believes that there will be openings for default annuitization options that go beyond the limitations of the July QLAC definition.
Hanney cites a recent Brookings Institute presentation by Iwry in which he stated that the Treasury “did very much leave the door open to other approaches that could be permitted in the lifetime income longevity annuity space.” As Iwry explained, “In no way is this intended to suggest that variable products or indexed annuities don't have a potentially important and very constructive place to play.” The Treasury is calling for industry suggestions to help inform future regulations, and we should all hope that additional options for providing greater retirement security are considered.
According to Brown, “the two Treasury pronouncements were extremely important as a symbolic gesture, a very important signal that this administration is supporting the concept of lifetime income.” But adding longevity annuities shouldn't be the last word on turning retirement savings into income “because there are still way too many areas that need to be settled before this market can flourish. There are multiple ways that one can think about incorporating lifetime income into QDIAs. The October legislation addresses one of those, and I think it's a great start.”
Are QLACs going to help defined contribution plans provide greater retirement security for Americans? A lot of plan sponsors who had never considered annuities are now going to give them a second look, and a lot of plan providers are already thinking about ways to offer more life-cycle products that incorporate lifetime income. With some luck and continued cooperation between regulators and the industry, we can start turning all those defined contributions into a better-defined income for retirees.