Risk Capacity 20

The IRS Addresses Longevity Risk in Retirement Plan Accounts

Risk Capacity 20

In our summary of risks facing retirees, we identified longevity (the potential to outlive one’s assets) as one that has increased through time with better awareness around health issues and medical advances leading to ever-longer life-expectancies. One way of mitigating this risk is through the purchase of an immediate annuity upon retirement or a deferred income annuity that would begin at a more advanced age. Furthermore, having annuity payments that increase with inflation can address another insidious risk facing retirees—inflation risk. Last week, we learned that the IRS will now allow defined contribution retirement plans like 401(k)s, as well as custodians of IRAs, to offer these products which are referred to as “qualified longevity annuity contracts” (or QLACs).

Prior to this regulation, retirees could not purchase a deferred income annuity in their traditional IRA or 401(k) because it would not meet the RMD (required minimum distribution) requirement that begins at age 70 and one-half. They currently do have the option of buying a variable or fixed annuity with a guaranteed minimum withdrawal benefit that can be used to meet RMD requirements, and once they annuitize, the IRS normally will consider the annuity payments to meet the RMD requirement. This new regulation will effectively allow a DC plan sponsor or an IRA custodian such as Schwab or Fidelity to choose one or more particular annuity products for plan participants or brokerage clients to use. For retirement plans, the plan participant should be able to rely on the fact that since either the plan sponsor or the advisor to the retirement plan is required to act as a fiduciary, the offered annuity will have been chosen with proper due diligence. Brokerage firms would also have a very strong incentive to only work with high quality insurance companies. For these purposes, we would measure quality via company financial strength (e.g., AM Best rating), the payout level compared to other similar companies, and reputation for customer service.

Under the new rules, a plan participant or IRA account holder can use $125,000 or up to 25% of the account balance (whichever is less) to buy the annuity. The $125,000 dollar limit will be allowed to increase with inflation. Payments on the annuity may not begin later than age 85. Annuity contracts are excluded from the account balance when calculating the required minimum distributions that begin at age 70 and one-half. The annuity may offer a “return-of-premium” rider where the annuitant’s beneficiary would receive the remaining annuity payments until the full premium had been paid out. Lastly, the annuity may not be structured as a variable annuity (where the policyholder’s funds are segregated and invested at the directive of the policyholder) or as an equity-indexed annuity (where the value depends on the movements of a market index).

A recent article in USA Today quoted Nobel Laureate and researcher Robert Merton who lauded this development:

“I applaud the provision allowing deferred annuities within 401(k) or any other retirement plan as a valuable tool for retirement drawdown. A deferred annuity beginning at 85 with no survivor benefits is an ideal control to provide (longevity) 'tail-risk' insurance. It will have a relatively low premium if purchased at retirement. It is thus a good core financial tool for working- and middle-class class retirees with non-complex financial situations to deal with the real fear of outliving ones assets”

Like Professor Merton, we at Index Fund Advisors are pleased with this new development, for many, a fixed guaranteed income for life provides peace of mind. We will be taking a careful look at the deferred income annuity market to determine the best options for serving the retirement plans we advise.