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December 02, 2014 at 04:35 AM
In February 2012, the IRS proposed regulations on a new type of annuity contract called a “Qualifying Longevity Annuity Contract” (QLAC), provoking considerable interest and discussion in the financial services industry. On July 2, 2014, final regulations were published, and the discussion continues, often marked by confusion and inaccuracies. Much of this confusion is the result of inconsistent terminology. Here, we aim to set the record straight, and provide some clarity about what all this really means for practitioners and their clients.
The “longevity annuity”
According to Prof. Moshe Milevsky, the concept of an annuity product that could be purchased at an early age, for relatively small premiums paid over many years, and that would only begin paying inflation-adjusted lifetime income benefits at an advanced age such as 80 or 85, has been around since the late 1970s. In 2004, Milevsky delved further into this idea with a paper introducing a concept product which he called an “Advanced-Life Delayed Annuity” (ALDA).
An ALDA would be a life annuity product (offering only a life contingent payout option and not any type of payout for only a specified period of years) that could be purchased years in advance of the income payments, guaranteeing the dollar value of those income payments, but offering no cash value or death benefit during the period from purchase until the Annuity Starting Date (ASD) — and often restricting the purchaser’s ability to select only an ASD of age 85 or similar advanced age.
According to Curtis Cloke, this type of annuity product first became approved to be offered for retail sale in 1979, but due to lack of marketing, it was not actually sold until 1999. It has generally been referred to as a “longevity annuity.”
The “deferred income annuity”
A more generalized version of the longevity annuity product, typically referred to as a “deferred income annuity” or DIA, has also been around since 1999. This variant often allows life and joint life-contingent, period certain, installment and cash refund annuity payout options, and may offer commutation or a death benefit payable at the annuitant’s death (before or after ASD).
It must be understood that longevity annuities and deferred income annuities are not two distinctly different types of contract. Each is a Deferred Income Annuity – an annuity contract which may be purchased well in advance of the ASD, where the amount of annuity income is guaranteed at the time of purchase. Some DIAs contain a particular combination of features that conform to Moshe Milevsky’s original “ALDA” concept – that is, no cash value, little or no flexibility as to the ASD, and only life-contingent payout options. These are essentially a sub-type of DIAs, often referred to as “longevity annuities.”
These more flexible contracts are often referred to as “DIAs,” as though they are different from “longevity annuities.” But the truth is that all these products are DIAs; some simply offer features and flexibility that others do not. While both longevity annuities and the more generalized and flexible DIA versions are currently offered, contracts of the DIA variety offering a death benefit and more flexibility as to ASD are, according to Curtis Cloke, more popular with consumers.
However, the new Treasury regulations on QLACs (which offer limited flexibility as to ASD and a “return of premium” death benefit but permit no cash or commutation value) may change this somewhat, as the new QLAC rules are closer to Milevsky’s ALDA-style longevity annuity type of DIA. DIAs represent only about 1 percent of current annuity sales, but their numbers are increasing and the new QLAC regulations may increase this trend.
One reason for the increasing popularity of all DIAs is increased consumer concern for income guarantees that will last a lifetime. Of course, other types of annuities can provide this benefit, but DIAs may offer greater financial leverage — the ratio of guaranteed benefits to premium cost, impacted by how annuitant mortality is utilized (mortality credits).
How and why the regulations were issued
All DIAs work fine in non-tax deferred accounts (accounts other than IRAs or qualified plans). But because some DIAs do not have a cash value (or other commutation/liquidity provisions) from which Required Minimum Distributions (RMDs) may be paid, a DIA with an ASD later than age 70½ has presented difficulties. It was this clash of longevity type DIA contract provisions with RMD requirements applying to IRAs and qualified plans that made it necessary for Treasury to provide regulations concerning the use of DIAs in IRAs and qualified plans.
The proposed QLAC regulations published March 26, 2012, offer a valuable insight into how and why these regulations came into being. The “Background” section states the following:
“On February 2, 2010, the Department of Labor, the IRS and the Department of the Treasury issued a ‘Request for Information Regarding Lifetime Income Options for Participants and Beneficiaries in Retirement Plans.’ That Request included questions relating to how the required minimum distribution rules affect defined contribution plan sponsors’ and participants’ interest in the offering and use of lifetime income. In particular, the Request for Information asks whether there were changes to the rules that could or should be considered to encourage arrangements under which participants can purchase deferred annuities that began at an advanced age (sometimes referred to as longevity annuities or longevity insurance).”
A number of commentators identified the required minimum distribution rules as an impediment to the utilization of these types of annuities. One such impediment that they noted is the requirement that, prior to annuitization, the value of the annuity be included in the account balance that is used to determine required minimum distributions. This requirement raises the risk that, if the remainder of the account has been depleted, the participant would have to commence distributions from the annuity earlier than anticipated in order to satisfy the required minimum distribution rules. Some commentators stated that if the deferred annuity permits a participant to accelerate the commencement of benefits, then, in order to take that contingency into account, the premium would be higher for a given level of annuity income regardless of whether the participant actually commences benefits at an earlier date. Some commentators also noted that longevity annuities often do not provide a commutation benefit, cash surrender value, or other similar feature.” (From Internal Revenue Bulletin 2012-13.)
What was to be done with DIAs having an ASD later than age 70½ (and no commutation or other liquidity feature)? According to Curtis Cloke, some DIA issuers accommodated IRA-held DIAs with ASD’s after age 70½ by utilizing the 12/31/prior year Actuarial Present Value annually reported to the IRS. These carriers believe, he says, that this meets a sufficient de facto cash balance reporting necessary to incorporate DIAs with other cash value assets to determine overall client RMD requirements.
Cloke reports that issuers of DIA contracts for products filed and approved just prior to 2006 suddenly began annual filings of Form 5498 when those contracts were held in tax-deferred accounts but that issuers of contracts for products filed well before 2006 did not do so, even for contracts held in such accounts. Prior to 2006, Cloke states that he had not seen such filings for DIAs. Why this change? Michael Kitces notes that new valuation and reporting rules for deferred annuities for RMD purposes were introduced in 2004 as part of an updated Treasury regulation (from Treasury Regulation 1.401(a)(9)-6, Q&A-12), with reporting that began in subsequent years.
Non-annuitized DIAs are indisputably deferred annuities, and it seemed obvious that these contracts, when held in tax-deferred accounts, would be subject to RMD rules. But what if they had no cash value? Insurers could report the Actuarial Present Value, but contract owners would still be responsible for paying RMDs attributable to that value. But what if they have liquidity (e.g., commutation or a cash value) to satisfy the RMD? If the taxpayer has other Traditional IRAs, the DIA-attributable RMD can be taken from another IRA. Cloke states that he recently sold a DIA with an ASD of age 78 to a 73-year-old purchaser’s Traditional IRA. That purchaser was required by the insurer to sign a disclosure statement confirming that he had sufficient other Traditional IRA assets to meet his Traditional IRA RMDs for the five-year deferral period.
But what if there are no other IRAs? Cloke reports that, when such an traditional IRA-held DIA is the only IRA asset of a contract owner, some insurers permit him or her to withdraw an amount equal to that RMD (based upon that Actuarial Present Value) after age 70½ but before Annuity Starting Date. Of course, such a withdrawal would result in an adjusted annuity benefit as of ASD, and such a liquidity provision might (adversely) impact the pricing of the DIA in the first place.
Thus, some investors may prefer to allocate IRA dollars to a DIA that does not allow any liquidity before the ASD (to improve the pricing of the DIA benefits in the future), but that still puts those investors in a position of risk if other IRAs might be depleted, such that they will now be unable to satisfy their RMD obligation at all. In other words, as Michael Kitces puts it, “What if I do not want to risk having insufficient IRA assets outside the DIA and I want in my IRA a DIA that doesn’t have a commutation/liquidity provision?” The final QLAC regulations solve that problem.
