Understanding Annuities: Qualified Longevity Annuity Contracts (QLACs)

It is no secret—people are living longer these days. The longer time horizon means more time spent in retirement and more concerns about funding all those extra years. No one wants to run out of money deep in retirement, so it is understandable many fear outliving their resources and not having adequate income for long-term care and other retirement expenses. For retirees with Individual Retirement Accounts (IRAs) and 401(k) savings funded with pretax money, the annuity industry has a product for you: Qualified Longevity Annuity Contracts (QLACs). They are a type of longevity annuity that allows payments to be deferred until sometime in the future. A QLAC lets you swap some money in your qualified retirement plan to guarantee monthly payments for the rest of your life after a specified date.

Although QLACs are designed to appear useful, they have several limitations you should weigh carefully.

Using QLACs in Retirement

QLACs are a type of deferred income annuity that can help reduce required minimum distributions (RMDs), which are the minimum amount you must withdraw from qualified accounts every year. RMDs force you to start withdrawing funds from your IRA and 401(k) accounts after you reach age 70½—so the IRS can tax it. In July 2014, the Treasury Department changed the rules so the value of QLACs is shielded from RMD consideration until age 85. So, if you convert a portion of your IRA or 401(k) savings into QLACs, that money isn’t subject to mandatory withdrawals when you hit 70½. This could lower your tax bill until you reach 85. Thereafter, annuity payments are factored into the calculation of your RMD and are taxed as ordinary income.

Another potential benefit of QLACs is they aren’t considered assets under Medicaid guidelines. Although the Affordable Care Act eliminated federal asset limits, some states impose their own asset tests, and they are still required for long-term care. So if you are (or would like to be) covered by Medicaid and eligible for long-term care, QLACs may help protect your assets from spend-down requirements.

Qualifying funding sources include IRA and 401(k) plans, as well as 403(b) and 457 retirement accounts for public school and government employees. But there are restrictions on how much you can put into a QLAC. In aggregate, only 25% of all your qualifying accounts up to a maximum of $130,000 is allowed, as of January 2018.

Once purchased, funds are irrevocably committed and annuity payments start at a predetermined date (up to age 85, by which time they must begin). You may be able to change the annuitization date depending on the contract, but that triggers a recalculation of the guaranteed payout. If you delay the RMDs until age 85, you will have a larger guaranteed payout, which means a potentially larger tax impact than if you had taken the RMD at 70½.

Pitfalls of Longevity Annuities

Although QLACs provide a lifetime income stream and help lower your tax bill for a time by allowing you to reduce and defer RMDs, are they worth it? In our view, the answer is frequently no. QLACs suffer many of the same drawbacks as any other annuity:

• Inflation: Inflation has averaged around 3% a year since 1925.[i] So for a retiree with a life expectancy of 85 years, inflation can result in a significant reduction in purchasing power over time. For example, say you receive an annuity income of $50,000 today and it comfortably covers your living expenses. To have the same amount of purchasing power in 20 years, you would need at least $90,000. Since companies typically do not adjust annuity income for inflation, this would represent a significant shortfall in your income’s purchasing power. In addition, if inflation is higher in the future than typical averages, the purchasing power of your income could erode even faster. While it may be possible to buy an inflation-adjusted rider and add it to some annuity contracts, this feature is costly and typically reduces annuity payments by 25-30% relative to comparable annuities with fixed payments and no inflation-adjusted riders.
• Risk of insurer becoming insolvent: An annuity is an insurance product offered by an insurance company designed to address the risk of you outliving your savings. Annuity providers often present annuities as a safe strategy that provides a guaranteed income stream. But what happens to your lump sum payment or income stream if the insurance company goes out of business? Say you purchase a QLAC with funds from a qualified employer-sponsored plan or Traditional IRA with up to 25% of your account balance as allowed by the IRS. Remember—you exchange the initial lump sum payment you make for the lifetime stream of guaranteed income payments. The funds are irrevocably committed. The guaranteed income is subject to the ability of the insurance company to make those payments. If the insurer fails, you stand a good chance of losing some or all of your money. State guaranty funds can often protect annuity owners if an insurance company fails.  However, the protection they offer is limited, differs from state to state and is unlikely to fully compensate the annuitant.
• Forgone growth: Although temporary RMD reductions might be appealing, QLACs aren’t necessary and may even be counterproductive to reaching your longer-term retirement goals. You should weigh the tax deferral you gain by purchasing a QLAC against forgone investment returns. When you lock up a lump sum of your retirement money in exchange for a guaranteed future income stream, you forgo investment returns from potential capital appreciation. The guaranteed income stream from the annuity might not adequately compensate for the loss of investment returns you would have had if you had an investment portfolio that was liquid. For example, if you had purchased a mix of bonds and stocks in your portfolio, you could receive cash flow from dividends on stocks, interest payments from bonds or from selectively selling stocks and/or bonds.

In short, a QLAC likely lowers lifetime returns and adds an extra layer of complication and paperwork compared to what a disciplined retirement plan can provide you without it.  

How Fisher Investments Can Help

If you own longevity annuities, have a portfolio of $500,000 or more and would like more in-depth evaluation, contact us.