Qualified longevity annuity contracts, or QLACs, allow an account owner to make contributions into an annuity contract and then defer income and distributions for years, with the intent of receiving an income at a future date. As a result of forfeiting access to the funds prior to receiving income, the contribution to the QLAC is not subject to the normal required minimum distribution rules associated with IRAs.
Qualified longevity annuities can be used to address a common concern of retirees: the fear of running out of money in retirement. Without knowing exactly how long they will live, the question then becomes “How do we appropriately plan for the future?”
Alternatively, we can run retirement projections until age 100 or beyond. The risk here may not be running out of money too soon; the risk may be not spending enough. You may be leaving chips on the table (or an estate that is larger than what you had intended) because you spent less early in retirement in an effort to save for your late 90s.
QLACs, when used appropriately, promise to pay income to a retiree at this later stage in life. This is income that will last for as long as the retiree lives. They are one valuable resource that may be used to address the issue of longevity and retirement income planning.
What Is a QLAC (Qualified Longevity Annuity Contract)?
A qualified longevity annuity contract is an annuity where one contributes money now with the expectation of receiving income in the future. During the period in between, there is no access to the cash, and no income is received.
In short, a qualified longevity annuity works like this:
- You contribute to a qualified longevity annuity contract.
- You wait for a specified amount of time, known as the deferral period, during which you receive nothing and have no access to the money.
- You turn on your annuity income, which pays you for the remainder of your life.
The amount of income you receive is subject to various factors, including how much you contribute to the contract, your age when you turn on the income, and your gender, among others.
Are QLACs a Good Deal?
There are several ways to evaluate whether or not QLACs are a good deal. The first evaluation assesses the value of the QLAC contract, calculating an internal rate of return on the contract over a number of years. Said another way, it calculates what rate of return you should expect.
To calculate the return, we must create a hypothetical example.
Let’s assume a sample contract for a 65-year-old male who contributes $125,000 into a QLAC. Let’s further assume two scenarios: one that begins delivering income at age 80 and another at age 85.
Based on illustrations provided by the insurance company, this hypothetical client will collect the following income. (This is not a full list of the available options but rather a list for illustrative purposes.)
- Age 80 – Annual income of $27,433
- Age 85 – Annual income of $54,399
From a practical standpoint, here is what is happening.
This client is giving up full access to $125,000. In exchange, he will receive $27,433 for life (if he chooses to start income at age 80) or $54,399 for life (if he begins income at age 85).
Using these figures, we value the contract as detailed below:
We can see the rate of return of this investment, assuming that income starts being received at age 80, is positive beginning in contract year 20. It takes 20 years from the date of the initial contribution to the contract to eke out a positive rate of return.
It isn’t until age 89 that the rate of return creeps above 4% and age 92 that it surpasses 5% (the average 65-year-old male today has a life expectancy of 84.3 years). Using life expectancy as a target (and rounding up to age 85), we see that the expected rate of return is calculated to be 1.59%.
So, back to the original question, is this a good deal or not?
To help answer this question, we should compare a QLAC to the available alternatives, one of which is an investment portfolio. If you would expect to earn a rate of return in an investment portfolio that exceeds the IRR’s calculated above, one could suggest that it makes sense to consider investing as opposed to contributing those funds to a QLAC.
Using a historical perspective as our guideline, an investment portfolio has far exceeded the IRRs as stated by the longevity annuity. Using a balanced Vanguard portfolio as a reference point (assuming a 50% equity and 50% fixed income allocation), we see that the average rate of return between 1926 and 2015 was 8.3%.
With that in mind, would you prefer the certainty of annuity income and a 0‒4% rate of return? Or would you retain the investment risk to maintain liquidity and the possibility for a better rate of return?
QLACs and Required Minimum Distributions
As stated earlier in the article, QLACs have the advantage of not being subject to RMDs. However, the question becomes “How valuable is this so-called benefit?”
Based on the calculations above, I could argue that it is not all that valuable. In fact, the benefit of delaying income would need to be HUGE in order to make up for the potential loss of earnings.
Understanding the rules of an RMD
At age 70.5, the IRS mandates that IRA owners must begin taking the required minimum distributions from their IRA account(s). The specific amount required is a percentage of assets based on the previous year-end balance. With every year that passes, the percentage that needs to be withdrawn increases because the older you are, the greater the percentage of the account balance that you need to take.
For some retirees, the amount that the IRS requires to be withdrawn from the IRA exceeds the amount that they need to meet their living expenses. If this is true, it’s possible that they would likely prefer to keep the money in the IRA (thus avoiding paying tax and continuing to let it grow tax deferred) rather than taking a distribution.
Unfortunately, this is not an option. In fact, the IRS even imposes a penalty on missed RMDs. The penalty is 50% of the amount that should have been withdrawn.
An Example of This Scenario
Let’s assume that a retiree has $1,000,000 in an IRA.
If we assume that the IRA holder turns 70.5, we can assume that all $1,000,000 will be subject to a required minimum distribution. Using the IRS table for required minimum distributions, we can calculate that this retiree will be required to withdraw $36,500. All $36,500 will be taxable income.
For comparison purposes, let’s assume that the same retiree contributes $125,000 to a QLAC just before the previous year-end. Because of this QLAC contribution, the previous year-end balance is now $875,000, not $1,000,000. Using the same RMD table, we can calculate the required minimum distribution to be $31,937, or $4,563 less than the first example.
If we assume a 25% tax bracket on $4,563, we can calculate a tax savings of $1,141 on the lesser withdrawal.
The question becomes “Does it make sense to contribute to a qualified longevity annuity simply to lower the required minimum distribution?” In this example, does it make sense to contribute $125,000 to the longevity annuity to save $1,141 in income taxes? Some suggest that answer to be no (and I tend to agree).
I personally don’t believe that it makes sense to trade liquidity and future income guarantees for a low IRR product and a few dollars in income tax savings (stated more correctly, additional tax deferral).
More That You Need to Know about QLACs
Qualified longevity annuities have a number of rules that they must follow. To remain qualified, longevity annuities must meet certain requirements. These requirements include the following:
- Only 25% of a retiree’s pre-tax retirement plan assets may be invested into a QLAC.
- The cumulative amount invested into all QLACs must not exceed the lesser of 25% of all pre-tax retirement plan assets or $125,000 (in 2016).
- Each spouse may contribute to the above-mentioned limits for their own retirement savings.
- QLAC payments must begin by the time the retiree reaches age 85.
- QLAC cannot have a surrender value. They can, however, have a guaranteed return of premium death benefit.
How Do Longevity Annuities Fit into a Retirement Plan?
Like all annuities, the longer you live, the more possible income you will receive from the annuity and the better “deal” it becomes. If you die sooner, you will receive less income from said annuity and “lose” (in an economic sense at least). Unfortunately, none of us know the answer to the longevity question.
Therefore, a true test of how QLACs fit into a retirement plan should include a rigorous analysis.
More than anything, qualified longevity annuities are another option to hedge against the risk of living too long and running out of money. Prior to purchase, they should be evaluated against other options, including a more traditional investment portfolio that has differing risk characteristics, such as a conservative, moderate, or aggressive portfolio.
Ultimately, it’s the detailed analysis, coupled with personal decision-making, that will determine whether or not these are a good fit for your plan.
In reference to general account obligations and guarantees, such as is present with fixed annuities, the ability for the insurance company to meet these obligations to policyholders are subject to sufficient capital, liquidity, cash flow and other resources of the insurance company.
The above figures are for illustrative purposes only and do not attempt to predict actual results of any particular investment.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.