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February 03, 2015 at 08:30 AM
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.
Regulatory Shift
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.
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