You’ve recently retired, and you go to the doctor, and get the news. “Jim, there’s now a safe surgical procedure for your terminal medical condition. All things considered, you now have a long life to live!”
This sounds like great news, right? It might be an unwelcomed prognosis if you assumed that your medical condition would lead to a short lifespan, and accordingly haven’t saved much for your retirement. Sure, you purchased life insurance for dying too soon, but did you buy longevity insurance for living too long?
By the end of this year, the last of the Baby Boomers turn age 60. As a group, they still have a lot of life to live. Particularly with the mind-boggling increases in medical technology, this segment of mostly retired Americans can look to significant increases in longevity. The challenge is that with this promising change in fortunes comes a dark side. The longer you live, the more chance there is that you will run out of income before you run out of oxygen. If your retirement plan assumes a thirty-year retirement, will you be able live comfortably if it turns out you’ll live another ten years beyond that? At the American College of Financial Services, our Retirement Income Literacy Survey clearly demonstrates that people underestimate their life expectancies.
A solution only an actuary could love
For the past decade, a solution has existed, but it has yet to catch on with the masses. Some have even called it the “spinach solution” – it’s good for you but many don’t like it. First, to be clear I love spinach – so that makes no sense to me. And second, ask any actuary, and they’ll tell you this is a great solution. So good, I invested in one.
The IRS calls it a QLAC, short for qualified longevity annuity contract. What it does is comparatively simple. You use your qualified dollars (for example IRA and 401(k) accounts) to buy longevity insurance at a deep discount. Put money into a QLAC while you’re still working, and have it begin paying you a lifetime income when you become elderly. Congress likes this idea so much that they’ve recently increased the maximum amount you can put into a QLAC to $200,000. And, in July the IRS issued regulations that make QLACs even easier to manage.
Consider a simple example. Sadie and Joe are a recently retired married couple, both age 65. Sadie wants to use $100,000 of her IRA to lock in a supplemental retirement income for both she and Joe. She transfers $100,000 to an insurance company for a QLAC. Her contract will grow tax deferred and then begin paying the couple $1,120 per month when Sadie turns age 75. This annuity will continue to be paid monthly as long as either Sadie or Joe is alive. Further, because this is part of a QLAC, her funds will not be subject to the RMD rules when Sadie reaches age 73. She doesn’t pay tax until she starts collecting income from her QLAC.
There are plenty of retirement savings tools out there, many for younger individuals to save towards retirement. But the appeal of a QLAC is that it allows retirees to project with certainty the cost of retirement income when they are elderly. In the example above, Sadie is paying a fixed amount upfront to secure a known lifetime income for her family in the future. It offers a concrete answer to the concern “do I have enough?” Much like Social Security or a defined benefit pension plan, the QLAC pays an income both Sadie and Joe cannot outlive.
By locking in this income, three positives occur for this couple:
– Knowing they have a lifetime income means that Sadie’s remaining retirement capital can be invested in growth-oriented investments. She’s purchased this income at a discount, and now can more confidently invest her other savings for the long-term.
– They can feel comfortable spending more in retirement. Research shows Americans with lifetime income guarantees feel a license to consume more of their retirement capital than their peers with equivalent wealth. They have locked in income, so they don’t have to hold back as much with their investments.
– Finally, Sadie has been the primary breadwinner, and feels a financial responsibility to her husband. If she dies first, she knows Joe will have some additional income even if she’s not around.
In essence, the couple obtains peace of mind knowing that living longer doesn’t have to be a dreaded outcome.
What’s the catch?
QLACs have been a little slow to catch on. This reminds me of Roth IRAs, which took years to be embraced. When Roths first came out, people couldn’t get past the idea of paying tax upfront. It took a lot of years for consumers to accept that the numbers don’t lie, and now Roths are all the rage. I expect a similar pattern with QLACs. That said, these are the three primary considerations that might be currently dampening sales.
1. Liquidity. The retiree will have to wait many years to begin receiving a monthly income. Significant life changes could potentially alter the owner’s income needs.
2. Interest Rates. Part of the QLAC payment includes some factored in growth due to interest crediting. If interest rates increase after the purchase of the contract, the retiree will be receiving an income for a long time that is based on a lower interest rate assumption.
3. Return. The rate of return on a QLAC is highly influenced by the owner’s life expectancy. If the annuitant lives longer than normal life expectancy, the return is high – potentially very high – as compared with other fixed investments such as bonds. But, if the owner dies shortly after payments begin, the QLAC will not have been as good of an investment.
These are legitimate issues to take into consideration. QLACs only make sense if the participant can afford to set aside money that won’t be needed until well into the future.
The issue of life expectancy, however, is more nuanced. Let’s return to the beginning of this column where a recent retiree was surprised to find he will live longer than expected.
Tell me when you’ll die; I’ll tell you what to buy
Time to turn money into income
QLACs can serve as an income floor even when an individual has an impaired – or comparatively uncertain – life expectancy. First, a QLAC can have a refund feature as part of the contract. If there is a premature death, the contract can be structured to return the payment to the owner’s beneficiaries. While there is a cost to this refund feature, it offers the security of knowing there will not be a loss of principal due to an early death.
Further, a QLAC may be a useful hedge for an individual with uncertain health prospects. Say you want to enjoy life while you can, but you’re worried about what happens if you live longer than expected. With a QLAC, you can take some current qualified money off the table and have it purchase an income stream that begins at, say, age 80. Particularly if a refund feature is included with the annuity, you are using deeply discounted dollars to purchase what is essentially longevity insurance. If you die too soon, you get your money back. If you live too long, you get an income you can’t outlive. It’s an economical way to have a “just in case” income source. With the rapid growth of medical technology, terminal illnesses may be curable. While this is a wonderful outcome, it also means you will live longer – and need income longer.
Consider this example: Miles, age 60, has a family history of poor heart conditions that makes him nervous about his life expectancy. He recently retired to enjoy life while he can. However, between his healthy lifestyle and the advancement of medical technology, he hopes he may still live a long life. In order to lock in some additional retirement income just in case, Miles uses $200,000 of his 401(k) account to purchase a QLAC. This annuity will begin paying out a lifetime income when he turns age 80, plus it will provide a cash refund feature. Based on a QLAC quoted by a top-rated company, Miles’ $100,000 would lock in $6,200 per month beginning at age 80 – that’s $74,400 per year.
Is this a good deal? Look at it this way. If Miles were to wait until age 80 to purchase a single premium annuity from that same company, he would need $778,798 to generate an equivalent annual income. Said differently, the required annual yield on his assets over the 20 years between age 60 and 80 would need to be 7.03%. Further, by having this money in a QLAC, he will not have to begin taking RMDs on the $100,000 until age 80. He’s saving on taxes until he starts receiving the income. Worse case – if he dies before age 80, his heirs get his principal back.
When we retire, a lot of “what ifs” arise. Lately, a big concern for many retirees is “what if I live too long?” A QLAC could be a financially efficient way to address this concern. Use some money now to provide an income for the “healthy you” of the future. If you want to unpack this topic with me in-person, I’ll be covering QLACs at The American College of Financial Service’s retirement planning conference Horizons.