Journal of Financial Planning: January 2014
David M. Cordell, Ph.D., CFP®, CFA, CLU®, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFP®, CFA, is professor of business law at Roger Williams University in Bristol, Rhode Island.
In a prior column, we addressed the concept of longevity insurance, which allows clients to hedge against the risk of outliving their resources (see “Hedging Longevity Risk for Worry-Free Retirement” in the May 2013 issue). In this column, we review the requirements that proposed regulations are likely to impose and suggest how advisers may wish to incorporate this approach to retirement planning for clients.
Longevity insurance typically is structured as a single premium deferred annuity with a specified future start date for payments. Essentially it is like buying an immediate life annuity with a postponed starting date. For example, a 65-year-old retiree can purchase an annuity that won’t begin making payments until she turns 85, but, like a normal life annuity, will continue to make payments for the rest of her life. Because the life expectancy of 65-year-old Caucasian women is 20 years, roughly half of those women will live beyond age 85. How likely they will live beyond age 85 is addressed by longevity insurance.
Payments from longevity insurance are considerably higher than those of a normal life annuity for three reasons: (1) the insurance company has use of the money for many years; (2) many purchasers will never collect payments because they will die before the starting date; and (3) most purchasers who do live to collect payments will collect them for very few years. Insurers typically offer bells and whistles, like a guarantee that the annuitant and/or survivors will receive payments equaling the premium paid, but every enhancement lowers the guaranteed payment.
Longevity insurance permits individuals to plan for retirement expenditures with greater certainty, reducing the concern about the prospect of running out of money.
Proposed Regulations Affecting Longevity Insurance
In February 2012, the IRS proposed regulations that would permit taxpayers to purchase longevity insurance inside of retirement accounts (Reg 115809-11). These regulations would permit taxpayers over age 70½ who hold longevity insurance inside of retirement plans to exclude the value of the longevity insurance policy when calculating their required minimum distributions (RMDs). By issuing these proposed regulations, the government effectively reduces the out-of-pocket cost of purchasing longevity insurance policies and implicitly endorses this type of planning for taxpayers.
Although these proposed regulations (as of the time of this writing) have not yet been adopted, there appears to be consensus among practitioners, reinforced off-the-record by regulatory authorities, that adoption is likely. Suggestions made to the IRS during the comment phase of the adoption process were generally positive, with practical suggestions on how to make the regulations more workable.
Under the proposed regulations, taxpayers holding retirement plans subject to RMDs would be able to purchase longevity insurance inside those plans, subject to certain limitations. Traditional defined benefit plans are excluded from the proposal, because these plans already provide a lifetime income for participants. Roth IRAs also are excluded, as Roth IRAs are not subject to RMDs. Presumably Roth 401(k) and Roth 403(b) accounts will be permitted to hold approved longevity insurance, because they are subject to RMD rules during the lifetime of the participant.
To qualify for the special benefits allowed under the proposed regulations, a qualified longevity annuity contract (QLAC)—an annuity contract that meets distribution requirements, premium limitations, and design limitations—must be purchased. The values of all annuity contracts classified as QLACs are excluded from the participant’s account balance when calculating RMDs.
Distribution Requirements for QLACs
Under the distribution requirement, the annuity contract must begin to make distributions no later than the month after the participant’s 85th birthday. Several insurance companies and practitioners have defaulted to age 85 because this age is a few years after average life expectancy based on current estimates. As implied earlier, setting the beginning date after average life expectancy decreases the premium relative to the projected payments due to time value of money principles and actuarial factors. All else equal, of course, the lower the cost of the premium, the more attractive longevity insurance becomes as a hedge against the possibility of outliving one’s resources.
Limitations on QLACs
Proposed regulations also impose a premium limitation when defining a QLAC. The premiums paid for the QLAC cannot exceed the lesser of $100,000 adjusted for inflation or 25 percent of the participant’s account balance as of the date of payment. This amount may seem low, but recall that the premium is being used to purchase an annuity that typically will not begin to make distributions for 20 years.
Also, payments are rather large as a percentage of the premium. For most individuals, the maximum premium allowed is likely to produce the desired cash flow, although in the current environment, low interest rates may be reducing guarantees and partially offsetting actuarial benefits. Longevity insurance policies purchased at younger ages will result in the greatest premium reduction.
There also are several limitations imposed on the design of an annuity contract if a plan participant wishes to classify it as a QLAC. Recall that the purpose of the QLAC is to provide a lifetime income stream once the participant reaches an advanced age, not to substitute for a testamentary transfer. QLACs, therefore, are permitted to provide only limited death benefits.
Because a major concern of most plan participants is providing sufficient income for their spouse, the QLAC rules permit a surviving spouse to receive a life annuity payment, although no greater than 100 percent of the payment that was received by the deceased participant. When the surviving spouse is not the sole beneficiary, death benefits available under the policy are limited to the normal requirements under the minimum distribution rules (I.R.C. §401(a)(9)(6)). Furthermore, to qualify as a QLAC, the contract must be an ordinary annuity (rather than a variable or equity indexed annuity), have no commutation benefit or cash surrender value, and state that the contract is intended to be a QLAC.
Other Aspects of QLAC Regulations
Insurance companies issuing QLACs are required to report contract information, including policy values, to the policy owner/plan participant. This is particularly important when the participant reaches age 70½ and RMDs begin. The participant must know the value of the annuity contract so it can be excluded from the total account value when completing the RMD calculation. Annuity providers are not required to report any information about the annuity contract to the IRS until payments under the annuity contract begin.
Prior to the publication of these proposed regulations, longevity insurance already was growing in popularity in the planning community. Increasing life expectancies and the perception of increased risk exposures in financial markets have highlighted the very real possibility of running out of money in retirement. Despite these risks, one of the objections that advisers often encounter when suggesting the use of longevity insurance is that the client may be paying for something that he or she will never benefit from if death occurs before the annuity starting date. Many clients are fearful of losing part of their capital that could have benefitted children and grandchildren if the client dies before receiving benefits from the annuity contract.
The proposed regulations address this concern by reducing the after-tax cost of longevity insurance policies, because clients can purchase longevity insurance with pre-tax dollars from their pension plans. The real cost of the longevity insurance policy to the plan participant who dies prior to the annuity starting date is not the premium paid, it is the premium paid reduced by the federal income taxes that the client would have paid had that amount been paid as a normal retirement distribution. Clients who live beyond the annuity starting date will receive annuity payments that will be subject to income tax, but if the client receives distributions from the retirement plan instead of the annuity, those distributions also would be subject to income tax.
Additional income tax deferral savings are achieved by excluding the value of the longevity insurance contract from the RMD calculation, thereby reducing the amount of the RMD that is subject to income tax beginning at age 70½. This deferral benefit further reduces the after-tax cost for a plan participant who purchases longevity insurance as a hedge against the possibility of running out of resources if he or she lives to an advanced age.
Longevity insurance has its limitations:
- The client loses control over a portion of the retirement portfolio. The amount contributed to the annuity contract cannot be independently invested or easily accessed if a sudden, unexpected need arises.
- Inflation will diminish the purchasing power of future payments.
- The after-tax value of the future annuity payments may decline as tax rates increase, and some degree of income tax planning flexibility is lost due to the fixed nature of the cash flow provided by the annuity.
The proposed regulations will help determine whether longevity insurance, addressing the possibility of running out of money, should be an integral part of a well-crafted retirement plan.