Journal of Financial Planning: January 2015
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., CFA, is a professor of business law at Roger Williams University in Bristol, Rhode Island.
In prior columns, we have discussed the use of longevity insurance in retirement planning and regulations that the Internal Revenue Service proposed for the use of longevity insurance. We now take a look at the final regulations adopted by the IRS.
Longevity insurance is a deferred immediate annuity contract used to hedge against the risk of outliving one’s resources. A typical example is a 65-year-old retiree who purchases an immediate annuity, usually through a tax-free or tax-deferred account such as a 401(k) or IRA, that does not begin to make payments until much later, usually age 85. The price of these annuities is rather low for three reasons. First, because the insurer doesn’t begin making payments until the annuitant is age 85 and life expectancy at age 85 is limited, the insurer will have to make relatively few payments. Second, because the average life expectancy of a 65 year old is less than 20 years, there is good chance that the insurer won’t have to make any payments. Third, because of the time value of money, payments that begin 20 or more years into the future are discounted heavily.
As with other immediate life annuities, longevity insurance allows retirees to manage the financial risk of living too long. One aspect of this approach allows retirees to spend more of their retirement funds in the more active early years of retirement, knowing that annuity payments will begin in the later years. Longevity insurance can also provide inflation protection, overcoming the limitation of a fixed retirement or pension income by generating a new cash flow at age 85 after years of increases in living expenses. In both cases, longevity insurance transfers onto an insurance company the financial uncertainty associated with living to an advanced age.
The IRS Chimes In
The IRS took notice as the use of longevity insurance became more popular. In 2012, the IRS proposed regulations to permit the purchase of longevity insurance inside of individual retirement accounts, subject to specified limits, and exempted the value of the longevity insurance policy from the IRA accounts for the purpose of calculating required minimum distributions. On July 1, 2014, the IRS adopted final regulations concerning longevity insurance.
The final regulations incorporate several suggestions from practitioners to provide more flexibility to individuals who wish to incorporate longevity insurance into their retirement portfolios.
J. Mark Iwry, senior adviser to the secretary of the Treasury and deputy assistant secretary for Retirement and Health Policy, said in the July 1, 2014 press release announcing the final rules, “All Americans deserve security in their later years and need effective tools to make the most of their hard-earned savings. As boomers approach retirement and life expectancies increase, longevity income annuities can be an important option to help Americans plan for retirement and ensure they have a regular stream of income for as long as they live.”
Under the final regulations adopted by the IRS, the value of a qualified longevity annuity contract (QLAC) is excluded from the account balance of a taxpayer when determining required minimum distribution amounts. To qualify as a QLAC, an annuity contract must be designated as longevity insurance upon purchase, must have aggregate premiums that do not exceed the pre-defined caps specified in the regulations, and must have an annuity starting date no later than the first day of the month after the account owner attains age 85. Furthermore, a QLAC may not be in the form of a variable annuity contract or equity-indexed contract, although it may be a participating contract and may provide for cost-of-living adjustments to the benefit amount.
The maximum amount that can be spent on longevity insurance inside IRAs or qualified plans is $125,000 or 25 percent of the account balance, whichever is lower. The dollar amount cap will be indexed for inflation on a forward-going basis in $10,000 increments. These dollar amounts are more generous than the caps set forth in the proposed regulations ($100,000 dollar amount, indexed for inflation in $25,000 increments). Individuals who inadvertently exceed the 25 percent or $125,000 limit on premium payments are permitted to correct the excess by reforming the contract without disqualifying the annuity purchase.
Although the dollar amounts specified in the regulations appear to be conservative, the Treasury believes that these limitations are necessary to constrain “undue deferral of distribution of an employee’s interest.” By imposing the cap, the Treasury effectively limits the degree to which a taxpayer can reduce the amount of the qualified balances subject to minimum distributions at age 70½. That is, although the taxpayer can purchase longevity insurance, removing the dollar value of the policy from the qualified plan balances that are subject to minimum distribution rules, the amount that can be postponed (effectively to age 85) is limited.
The Treasury’s explanation of the changes to the final regulations recognized taxpayer comments suggesting a need to increase the limit over the proposed $100,000 threshold by adding $25,000 to that amount, but pointed out that a significant annuity benefit could be purchased within the limits proposed. For example, the Treasury estimated that a 70-year-old individual could purchase a deferred annuity commencing at age 85 with an annual payout between $26,000 and $42,000 (depending on actuarial assumptions and the form of the annuity) for a premium payment of approximately $100,000.
Under the final regulations, the required beginning date for annuity distributions (the first day of the month after attainment of age 85) will be adjusted on a forward-going basis to reflect changes in expected mortality. The adjustments to the required beginning date, however, are expected to be less frequent than the inflation adjustments made to the $125,000 premium limit. This adjustment would be necessary to maintain the pricing advantage of longevity insurance contracts.\Currently, average life expectancy is below the required beginning date for the longevity insurance contract, which permits an actuarial adjustment to be made to the initial premium to reflect the probability that the purchaser will die before the annuity starting date. If average life expectancy increases beyond age 85 and the required beginning date for annuity payments remains at age 85, a large portion of the discount attributed to age will disappear. This will reduce the annuity payment that can be guaranteed under the contract since the premium is capped at $125,000 under the regulations. If average life expectancy increases without a commensurate increase in the age that triggers the required beginning date for the longevity insurance contract, the use of longevity insurance will become less attractive.
Greater Contract Flexibility
Another significant change to the proposed regulations concerns the types of annuity contracts that can be used as QLACs. The proposed regulations limited QLACs to single life annuities and to contracts that provided only a life annuity payable to a designated beneficiary. The final regulations permit QLACs to include return of premium features as well. The return of premium may even be payable before the scheduled start date of the annuity if the annuitant should die before the start date. Whether death is before or after the start date, return of premium must be paid no later than the end of the calendar year after the individual’s death, or the end of the calendar year after the death of the participant’s spouse.
Return of premium features may be valuable for taxpayers who wish to use all of their retirement funds during early retirement, but would still like to leave an inheritance for their heirs if they die after the longevity insurance contract begins. Under current law, those amounts could be distributed directly to plan beneficiaries, or could be stretched out over the lifetime of the beneficiaries. Planners and clients should be aware, though, that the Obama administration has proposed changes to the minimum distribution rules that would require amounts remaining in retirement accounts at the death of a participant to be paid out within five years, effectively eliminating the value of the so-called stretch IRA.
Avoiding the Medicare Surtax
The Affordable Care Act imposed a 3.8 percent Medicare surtax on distributions from annuity contracts held by high-income taxpayers. A high-income taxpayer is a single individual with adjusted gross income over $200,000 or a married couple filing jointly with adjusted gross income over $250,000. The 3.8 percent surtax does not apply, however, to distributions from pension plans and IRAs.
In addition to planning and minimum distribution benefits afforded to users of longevity insurance, taxpayers subject to the 3.8 percent Medicare surtax on annuity distributions can avoid that tax by purchasing an annuity contract inside of a pension plan or IRA. This lowers the effective cost of employing longevity insurance as part of a client’s risk management and retirement income plan if that client is a high-income taxpayer.
A Final Thought
The Treasury and IRS have facilitated the use of longevity insurance inside of retirement accounts by excluding the value of longevity insurance contracts when calculating minimum distribution rules. Individuals who have concerns about extended life and the possibility of running out of money during retirement can now use longevity insurance, with the IRS’s blessing, bringing more certainty to their retirement income projections, and more peace of mind to themselves and their families.