This is the sixth and final article in a series on annuities.
In February of this year, the Internal Revenue Service (IRS) and the Department of the Treasury, in cooperation with the White House, published a series of revenue rulings and proposed regulations designed to encourage annuitization under defined contribution plans. This was one element of the Obama administration’s effort to focus on the policy goal that tax-preferred retirement savings should be used to provide lifetime retirement income. One of the proposed regulations defined a class of products known as “qualified longevity annuity contracts,” or QLACs, which are excluded from the account balance used to determine Required Minimum Distributions (RMDs). This article will provide an actuarial perspective on the development of products that would qualify as QLACs.
Qualified longevity annuity contracts
In response to the “Request for Information on Lifetime Income Options for Participants and Beneficiaries in Retirement Plans” by the Treasury and Department of Labor (DOL) in February 2010, representatives of the life insurance industry requested changes to the RMD rules to facilitate the use of longevity insurance in qualified defined contribution plans. The RMD rules provide for minimum annual distributions from qualified retirement plans based on the fund balance and the age of the participant. The February report from the President’s Council of Economic Advisors, called “Supporting Retirement for American Families” (CEA Report), observed that while the current market for longevity annuities is very small, interest in the product has been increasing. Because longevity annuities typically are purchased at or near retirement but do not begin paying benefits until considerably later, they can be offered at a fraction of the cost of annuities that pay immediate benefits, thus allowing retirees protection against the risks of extended longevity at an affordable price, while also allowing them to retain most of their wealth. By exempting longevity annuities (up to a specified limit) from the RMD rules, it is hoped that individuals under defined-contribution plans will be encouraged to use an “affordable” portion of their account balance to purchase a longevity annuity. The proposed regulations apply to tax-qualified defined-contribution plans under section 401(a), section 403(b), individual retirement annuities and accounts (IRA) under section 408 and eligible governmental section 457 plans. A QLAC may also be purchased in an IRA.
Under the proposed regulations, a QLAC is defined as “an annuity contract (that is not a variable contract under section 817, equity-indexed contract or similar contract) that is purchased from an insurance company for an employee.” That is, under the proposed regulations, a QLAC would exclude variable contracts, equity-indexed contracts or similar products, because they are seen as inconsistent with the purpose of a QLAC, which is to provide a predictable stream of lifetime income. In addition, the proposed regulation notes that exposure to equity-based returns is available through control over the remaining portion of the account balance so that a participant can achieve adequate diversification through means other than the QLAC.
The proposed regulations also provide that, in order to be a QLAC, consistent with the affordability concept, the contract is not permitted to make available any commutation benefit, cash surrender value or other similar feature. As in the case of the limitations on benefits payable after death, these limitations maximize the benefit of survivorship, thus allowing an annuity contract to maximize the annuity payments that are made while a participant or beneficiary is alive. Additionally, the proposed regulation states that having a limited set of product options available to purchasers would make these contracts more readily understandable and enhance product comparability. The proposed regulations provide that a contract must be specifically identified as a QLAC at issue to ensure that the issuer, participant, plan sponsor and IRS know that the rules applicable to QLACs apply.
The proposed regulations further provide that, in order to constitute a QLAC, the amount of the premiums paid for the contract under the plan on a given date may not exceed the lesser of a dollar or a percentage limitation. The proposed regulations prescribe rules for applying these limitations to participants who purchase multiple contracts or who make multiple premium payments for the same contract. Under the dollar limitation, the aggregate amount of the premiums paid for QLACs under a plan may not exceed $100,000. Under the percentage limitation, the amount of the premiums paid for a contract under the plan may not exceed an amount equal to 25 percent of the employee’s account balance on the date of payment. However, if on or before the date of a premium payment, an employee has paid premiums for the same contract or for any other contract that is intended to be a QLAC and that is held or purchased for the employee under the plan, the maximum amount under the 25 percent limit is reduced by the amount of those other payments.
The industry response to the proposed regulations has generally been positive. These have dealt with permissible product designs, encouraging additional flexibility in the types of products permitted; modifications to the limits that the proposed regulations placed on QLAC premiums; technical clarifications to the regulations and coordination with the on-reporting and recordkeeping issues.
QLAC design considerations
Product development for life insurance and annuity products typically starts within the life insurance industry itself in response to market research, often reflecting input from life insurance producers and others who distribute insurance products. However, the design of the QLAC is provided in the proposed regulations that outline very specific product parameters that must be met for an annuity product to be considered a QLAC. The QLAC itself is a form of deferred payout annuity, a product that existed in the life insurance industry many years ago, but had largely disappeared from the market until very recently, when a handful of companies began offering longevity insurance products.
A key policy driver of the Obama administration’s initiative to make longevity insurance accessible to retirees under defined contribution plans is the change in retirement plans from the traditionally defined benefit retirement format, which provided guaranteed income for life. A defined benefit plan effectively provided pooling of longevity risk through the plan, while a defined contribution plan shifts the risk to the individual retiree. At the same time, as mortality among the older population has improved, retirees’ longer lives create a risk that their savings will be insufficient to provide lifetime income. Conceptually, longevity insurance can be thought of as a way of allowing retirees to divide their longevity risk between a self-insured component, in which the individual bears the risk, and an “insured” component, in which the risk is pooled.
The relative cost of providing an annuity benefit is dependent on three principle factors:
- The number of individuals alive when benefits commence relative to the number who have purchased coverage;
- The interest rate assumed in pricing the benefit; and
- The degree to which the benefit of survivorship is diluted by death and withdrawal benefit.
Under a “pure” longevity insurance coverage (i.e., one with no death or surrender benefits), the longer annuity payments are deferred, the greater the payout to the remaining covered lives; that is, the longer coverage is extended to the tail of the survivorship table, the greater the benefits payable to the surviving lives. However, adding benefits payable on death or surrender dilutes the benefit of survivorship, thus increasing the actuarial cost of coverage.
With respect to the QLAC, the proposed regulations provide a “pure” form of longevity insurance, thus reducing the actuarial cost of providing the benefits, but also resulting in many insureds not receiving any payment from their longevity insurance. As outlined in the proposed regulation, the Obama administration’s QLAC design emphasizes simplicity of product design and a low actuarial cost. That is, if an insurance payout is very unlikely, the actuarial cost of the benefits is low relative to self-insurance, and insurance can provide substantial returns to those receiving benefits. Alternatively, when insurance payouts are highly likely, as would occur for an immediate annuity, insurance cannot be provided at much of a discount to self-insurance.
From an actuarial perspective, the operation of longevity insurance generally and QLACs specifically, can be illustrated through a Survivorship Curve. As shown in the chart, it represents the number of lives that continue to survive out of a population of 1,000 insured lives at inception, in this case females, beginning at age 65. By purchasing a QLAC, a plan participant can choose what segment of the Survivorship Curve to insure, thus shifting some degree of risk to an insured pool.
For example, if an immediate annuity were purchased at age 65, the longevity risk over the entire Survivorship Curve has been insured. The longer that benefits are deferred, because of the fewer number of surviving insureds, the less the cost, but the likelihood that a benefit will be paid to a particular insured is also reduced. In some respects, the longer the payment of benefits is deferred, the more the longevity insurance appears to be akin to “catastrophic” insurance rather than a pure annuity. A typical longevity insurance design is to defer the payment of annuity benefits for a period at or near life expectancy. Life expectancy for a female age 65 using the Society of Actuaries 2012 Individual Annuity Mortality Basic Table is nearly 24.5 years. As illustrated in the Survivorship Curve, this simply means that at age 89, half of a population that started out at age 65 has died, while the other half is still alive. However, if the payout is deferred for 20 years to age 85, then only approximately 60 percent of the lives that began at age 65 receive benefits. In that case, the first 20 years of the longevity risk has been “self-insured” while the remaining lifetime is “insured.” Since 40 percent of the insureds initially covered do not receive benefits, the payments to those surviving are correspondingly increased.
The future of QLACs
As noted in the CEA Report, the proposed regulations are intended to “remove barriers that have prevented annuity providers and plans from offering the full array of such options, bringing valuable choice to retirement savers.” With the status of the longevity annuities clarified under section 72, as well as under the RMD rules, it will be interesting to see if a market develops for longevity products generally and QLACs specifically. For the initiative to encourage annuitization to bear fruit and succeed will require efforts beyond the proposed QLAC regulations. Insurance companies must embrace longevity insurance as a part of their annuity portfolios. Some companies have offered longevity insurance, but the market must expand where the plan participants have access to a robust QLAC market. Companies that currently administer 401(k) plans must either decide to offer a QLAC or be willing to give those funds to a competitor for longevity insurance. Plan participants must also embrace the concept. One way to educate plan participants is to illustrate plan balances as both the fund value and the potential income stream. However, to accomplish this, some agreement must be reached as to the methodology that will be used to project the future income. Support from plan sponsors, as well as regulatory support from the DOL, is also critical to the infrastructure needed beyond the finalization of the QLAC proposed regulation. However, it does provide the industry with an opportunity to offer a product solution to the challenge of providing sustainable retirement income.