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Who Should Buy a QLAC (And Who Should Not?)

 Introduction

Who should consider buying a Qualified Longevity Annuity Contract (a “QLAC”)?  Who should not? 

A QLAC is a general account annuity that meets tests established by the Internal Revenue Service (“IRS”) in 2014.  The QLAC’s start date can be as late as the buyer’s 85th birthday.  The annuity payments continue for the life of the buyer (or the buyer and spouse). In this respect, the distributions are somewhat like social security benefits, except they start later. A QLAC premium (A Cap is described below) is withdrawn from a traditional IRA[1] without triggering a taxable distribution.  The IRA asset account is reduced by the premium distribution for purposes of computing the Required Minimum Distribution beginning at age 72.  Because the QLAC premium distribution was not taxed, the QLAC annuity payments are all taxable upon receipt.  (Please try our RMD and QLAC annuity benefit calculator to see how this works.)

Why Not Buy a QLAC?

At the latest, planning for retirement should begin in one’s early sixties or at least sometime during the decade after that. Some people will not be concerned about running out of savings during their retirements.  Below are examples of persons who are unlikely to be QLAC buyers:

  • A beneficiary of a defined benefit plan that provides a large, fixed benefit for life;
  • An owner of defined contribution plans (401(k)s, IRAs, etc.) with combined asset balances more than $1.5 million;
  • An investor with a portfolio of assets that generate adequate income to meet retirement living expenses;
  • An individual whose retirement planning focus is about to whom her estate will be distributed; and
  • A person with a limited life expectancy due to a disability or illness.

It is hard to imagine any of the above persons buying a QLAC unless their focus is purely on tax deferral.  

Who Should Consider Buying a QLAC?

There are many more who should consider a QLAC in their retirement planning. Examples of people who look into a QLAC include:

  • An owner of defined contribution plans (e.g., 401(k)s, IRAs) with combined asset balances less than $1.5 million and who has no defined retirement benefits;
  • Someone concerned about becoming a burden to his or her children during retirement; 
  • A taxpayer whose social security benefits will be a material part of his or her retirement income;
  • A person with no assets outside a home and defined contribution savings; and
  • Someone in good health and with a family history of longevity.

 Fear of out-living one’s assets is the common concern of people in this second group.   Social security benefits, in of themselves, fall short of their living cost in retirement. Further, most do not want to ask for financial help from their children or other relatives.   As a result, they want to find a way to make their savings last for life.

A QLAC addresses this concern by creating a lifetime cash flow starting before age 85. With a QLAC purchased say 15 years earlier, the annual benefit can equal anywhere from 25% to 35% of the premium.

To date, QLACs sales have not caught up to the need in the marketplace. Why?  The product is less than four years old. Many future and current retirees are not aware that QLACs exist.  Others have heard of QLACs but from a party with a vested interest in maintaining funds under management who have made a negative comment.  Below are criticisms and rebuttals.

Life Expectancy

Here, an argument is made that a retiree can make his funds last for her life expectancy. As previously noted, projected mortality is part of the criteria in deciding whether a person is a QLAC candidate. People with terminal diseases have short life horizons. Others, with less cloudy futures, ask, “How long can I expect to live?” The only way to answer the question is to look at an actuarial table. Still, it is essential to look at the right table.

          2016 Table for a 65-Year-Old  Sex                    Life Expectancy

          Social Security Administration      Female             21.6 years (i.e., age 86.6)

          SOA Annuity Table for 2016          Female             25.1 years (i.e., age 90.1)

For retirees with savings, the Society of Actuaries table is the right choice.  Longevity has been shown to correlate with income and savings.  The Social Security table includes low-income earners and those who have failed to save. The Society of Actuaries table focuses on a more narrow mix.

The definition of, “Life Expectancy” is also important.  The term does not mean that a group of like-aged (a “cohort”) females will all die when they reach their life expectancy (e.g.,. age 90).   Instead, it means that of an original cohort, 50% of the group will be deceased and 50% will be alive when the survivors reach age 90.  Further, the Society of Actuaries predicts that at age 100 10% of the original cohort (i.e., 20% of those alive at age 90) will still be with us.  At age 105, about 1% will still be living.

Of course, on average males die before females. The Society of Actuaries predicts a male age 65 has a life expectancy of about 23 years.  The slope of the male mortality curve follows the female curve – 10% of the males make it to age 98. 

Life expectancy increases when the actuaries compute the survival probability for at least one of a married couple (born on the same day).  At age 65, that life expectancy becomes 29 years or age 94.

So, it is incorrect to predict that savings need only last to one’s life expectancy.   There is a reasonable chance that each of us may live ten years or more past our actuarial life expectancy.  Indeed, life expectancy has been growing and will continue to increase as medical treatments improve.  No matter how long it may be, providing for the tail end of life is what a QLAC is all about.

'Bad Investment' or Good Insurance?

Some money managers have branded a QLAC (and other life annuities) as bad investments. Still, a QLAC is not an investment – it is an insurance contract.  It pays no matter how long you live.  It does not pay after you die, i.e., when you no longer need the money.

Analogies abound. Social security is an example, although it is a mandatory government-sponsored plan.  On every payday, the employee and the employer pay into the social security trust fund.  After retirement (for social security purposes), each month a social security distribution is paid to the former employee – until he or she dies.  If an individual dies before benefit eligibility, their estate receives nothing – there is no refund of social security taxes previously paid to the government.

The same logic applies to defined benefit pension plans sponsored by private employers.  The plan sponsor contributes to the pension plan fund, and after retirement, the program pays a scheduled benefit – until he dies. An early death does not trigger a plan refund to the employer or the employee.

To summarize, a QLAC converts a portion of retirement savings from a defined contribution plan into a defined benefit plan. That conversion is what creates peace of mind for QLAC buyers - they have covered their late in life living costs no matter how long they live.

Early Death Refund

Unlike social security or a defined benefit pension plan, QLAC buyers can elect a Return of Premium (“ROP”) policy option.  This election provides that when a beneficiary dies, the cumulative distributions have to equal at least the premium paid.  For example, assume a QLAC premium of $20,500 and a scheduled benefit of $5,000 per year.  If the QLAC owner dies after collecting two years of $5,000 ten, then his or her estate will receive a ROP check for $10,500. 

There is an intuitive appeal to getting your money back with a ROP election. Still, the annuity benefit amount is reduced when a ROP election is made. It pays to examine annuity benefits with and without ROP to examine the tradeoffs.  Remember, a QLAC is about not being a burden on your children – a QLAC is not about creating an estate for children to inherit.

'Equities Are Better?'

From time to time, a money manager may argue that the stock market’s long-term rate of return is 10%.  For example, they will assume an annual 10% return on savings (the return rate does not apply to a QLAC) and the same retirement distributions with or without a QLAC. The basket without a QLAC will out-perform the basket with a QLAC.  The problem with this analysis is that the money manager will not and cannot give the IRA owner a guarantee that his recommended investments will generate a consistent 10% rate of return. Equities can be volatile – up and down. Long-term averages do not pay bills when the stock market declines 10% or 20% in a year of retirement. (Please see our article about the challenges of Sequence Risk for more on this concern.)


Insurance is a product for people who cannot afford a given risk or loss.  A car owner buys collision insurance because she cannot afford to replace her car. A QLAC buyer is doing the same thing – she cannot afford the loss of income in her later life.

No QLAC Surrender – Longevity vs. Liquidity

The IRS QLAC regulations state that the policy cannot have a surrender value.  The QLAC contract is irrevocable.  Once the premium is paid and the contract is delivered, there is no going back.  While reducing the flexibility of the contract for the buyer, this provision enables the carrier actuaries to create the highest payouts.  If the risk of surrender were a factor, the annuity payments would be much lower. (Consider the effect of the ROP election discussed above.)

To be sure, a QLAC is not a liquid asset.  A QLAC should not be used to fund discretionary spending. Instead, the focus should be on funding the projected annual cost of living.

Also, note that the IRS created a maximum lifetime QLAC premium per participant.  The QLAC premium(s) cannot exceed the lesser of $135,000 or 25% of the IRA fair market value (the “Cap”).  After a QLAC premium withdrawal, 75% or more of their IRA assets remain to invest in stock or bonds. To meet living expenses, the owner can withdraw from the IRA before the QLAC annuity start date.  For most retirees, these withdrawals can equal the future QLAC annuity amount. Also, the withdrawals can continue until the QLAC annuity start date[2].

Carrier Ratings & Persistency

Insurance companies issue QLAC contracts.  After the initial deferral period of 10 to 20 years, the underwriter will be paying benefits for decades after that.  This payment stream is like a corporation issuing a bond for 30 to 40 years, except there is no defined termination date with a QLAC. 

How secure is the carrier’s promise to pay? There are over a dozen top insurance companies that offer QLACs.  Without exception, each one has a long history and has high industry ratings.  (See our carriers page to see the year founded and AM Best's ratings of leading QLAC carriers.)  Other than tax rules, there is no federal government oversight of the insurance industry. Instead, the states regulate and license the insurers.  The states collect premium taxes where the insurance companies do business.

To date, carrier bankruptcies have been rare. When a carrier did become insolvent in the past decades, the state’s insurance department took control of the company. During the rehabilitation, the regulators' primary goal is to protect the policy owners. Often, the solution is to move policies from the distressed company to another and stronger carrier.  Essentially, the state insurance regulators is a performance guarantor of the carrier’s they regulate.

Silk Out of Sow’s Ear

Unfortunately, the old saying -No Silk out of Sow’s Ear – applies to QLACs.  If there are minimal savings in someone’s IRA, there is no way to convert 25% of a small number into a big number.  There must be available savings to purchase a QLAC - which generates a useful future annuity.

If a person wants to buy an immediate annuity[3], a QLAC should not be on the shopping list.  QLACs are only available as deferred annuities. QLACs perform best when the deferral period is ten years or more. Also, QLACs shine when the annuity start date is on or after the 80th birthdate of a QLAC owner. Three-quarters of one’s savings should be able to get a person to their 80th birthday or later. The purpose of a QLAC is to insure against longevity risk.


Summary

A QLAC is not for the person with no concern about running out of assets or savings during his or her lifetime. He or she does not have a risk to insure.

A QLAC provides income certainty during the later years of retirement.  Its distributions are for life.  This deferred annuity typically starts at age 80 or after.  A QLAC premium can be funded by a traditional IRA without triggering taxation of the allowed withdrawal. The amount of withdrawal cannot exceed 25% of retirement assets.  The limit is $135,000.

Candidates for a QLAC are those individuals that may outlive their savings. Most QLAC buyers have a reasonable expectation to survive well into their late 80s or 90s.

Want to learn more? Check out our videos page to see additional QLACguru videos.  See our calculators page to develop an anonymous RMD calculation and estimated QLAC quote. Answer specific questions by going to our Knowledgebase page.  Visit our blogs page for in-depth articles on a variety of topics including how QLACs help with sequence Sequence Risk, how QLACs are similar to and different from Social Securitybest practices in buying a QLAC as well as many other topics. Free Consultation.  If you would like us to develop a free RMD analysis and illustration of how a QLAC might work for you, please click here.





[1] In addition to an IRA, other Internal Revenue Code accounts can be used to fund a QLAC.  These are known as 401(k), 403(b) and 457(b) tax-qualified savings accounts. Herein, references to an IRA are meant to include the other three tax-qualified accounts.  Further, a Keogh savings account is not eligible for a QLAC withdrawal.

[2] The projection assumption is that IRA investments do not lose money in any withdrawal year. Each year can show a zero rate of return and still provide adequate withdrawals as described above.

[3] When annuity distributions begin within 12 months of the premium payment, the annuity is labeled as “immediate.” 


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