Longevity annuities: Why clients should consider them

Frank and Jenna, both 65 and in good health, have roughly $2 million saved for retirement, but Frank is reluctant to take the extended European vacation they had long promised themselves.

"What if we live into our 90s and the markets tank?" he says. "We might run out of money." Perplexed by his hesitation about spending, Jenna suggests they speak with their CPA financial planner, who explains that one option would be to buy a longevity annuity.

After further consultations, the hypothetical couple take 10% ($200,000) of their retirement nest egg and purchase an annuity that will pay $65,000 each year beginning when they reach age 85 for as long as either of them is alive.

Longevity annuities are a type of annuity that will "kick in if you're still alive at a given age to ensure that no matter what's happened in your portfolio, you have some amount of money to live," said David Blanchett, Ph.D., who heads retirement research at PGIM DC Solutions, the global investment management business of Prudential Financial Inc.

Low-cost longevity protection

Blanchett observed in an interview that longevity annuities are "a relatively low-cost way to provide longevity protection." While single-premium immediate annuities are expensive because the annuity payments begin right away, longevity annuities "cost a lot less because the guarantee starts at some point in the future." In addition, because actuaries can predict that a certain percentage of the annuity purchasers won't live long enough to receive a payout (to age 80 or 85, say), those who do survive receive correspondingly greater monthly annuity payments (calculated using the concept of "mortality credits").

This makes longevity annuities "a very economically efficient way to create income that's guaranteed for life," Blanchett said.

Michael Finke, Ph.D., professor of wealth management at The American College of Financial Services, who will speak about annuities at this year's AICPA & CIMA ENGAGE 2023 conference, concurred in this positive opinion of longevity annuities. He and others who research retirement view longevity annuities as "the ideal solution to getting rid of longevity risk in a tax-efficient fashion," he said. He especially highlighted qualified longevity annuity contracts, or QLACs, which are purchased with qualified funds such as those in a 401(k) or an IRA.

Which clients they're best for

Longevity annuities are ideal for clients whose worries about outliving their money are preventing them from enjoying their retirement years, like the hypothetical couple Frank and Jenna above. In Blanchett's view, whether to buy a longevity annuity is "very much a conversation about how someone feels about spending their portfolio."

"Even if you're radically overfunded for retirement, if you're not willing to go on cruises or do things that you enjoy because you're worried about outliving your resources, OK, we can fix that" with a longevity annuity, Blanchett said.

"What annuities do, behaviorally," Finke said, "is give the client a pathway to spending down the money that they've saved without the fear that they're going to run out."

It almost goes without saying that longevity annuities — also referred to as deferred income annuities or delayed income annuities — are best for healthy clients who are optimistic about living long enough to collect the annuity payments when they begin, typically at age 80 or 85.

Generally, high-wealth people are the ones who purchase longevity annuities, Finke said. The product might not be as worthwhile for average-wealth clients because, for one thing, longevity annuities "are priced based on the type of person who has enough money to buy one of these" — typically, wealthy Americans, who tend to live longer. In other words, the mortality tables reflect the longer-lived person who tends to buy an income annuity. But for certain clients of average wealth, a QLAC may be a sensible purchase.

For clients in general, the primary strategy to consider for increasing their guaranteed stream of lifetime income is to spend down savings, if necessary, as a bridge to delay claiming Social Security until age 70, both Finke and Blanchett said. Maximizing one's monthly government check in this manner is advantageous especially because Social Security, which is essentially a government-funded annuity, comes with an annual cost-of-living adjustment.

Why clients hesitate to buy them

While academic researchers laud them, longevity annuities have yet to catch on widely with clients. They "are very behaviorally difficult to buy," Blanchett said, noting that clients may think: "What do you mean? I'm going to allocate $100,000 to buy this annuity where if I'm alive in 15 years, it starts paying me?" Agreeing, Finke described these annuities as "probably the most difficult financial product to sell."

In addition, some financial advisers have a negative perception of annuities in general, which may be partly because of some poor products on the market or their price, but, Finke said, they should rethink these negative views. Perhaps in some cases, too, advisers may be reluctant to remove money from their assets under management, he said.

Worries about insurance company solvency may be another reason clients hesitate to buy longevity annuities. "You really do need to pay attention to credit quality of the insurance company," Finke said, because the payout does not begin for 15 or 20 years.

Also, some clients may be reluctant to buy a longevity annuity because of concern about future inflation eroding the value of the annuity payments. While a client can pay extra for an annuity the payments of which will increase annually by a fixed percentage (such as 2% or 3%), this does not truly protect against inflation, both Finke and Blanchett said.

Tax aspects

Longevity annuities have certain tax advantages. If one is purchased through a qualified retirement plan or an IRA, "you get the QLAC opportunity," Finke noted. This includes being able to buy the QLAC with pretax funds. Also, the investment in the QLAC is not counted in calculating current required minimum distributions (RMDs) from qualified retirement plans, which may save substantially on taxes.

The maximum amount an individual can invest tax-deferred in a QLAC is $200,000 (indexed for inflation). If a workplace retirement plan doesn't offer QLACs, a client could roll over funds to an IRA to buy the QLAC, Blanchett said.

Purchasing a longevity annuity through a taxable investment account has significant tax benefits, too. Blanchett highlighted that you won't be taxed on the annuity income until you begin receiving payments (say, 15 or 20 years in the future), and the tax is only on the amount of income above the premium paid. "There is a little bit of 'tax alpha' that you get from buying these in taxable accounts versus qualified accounts, given the way that annuities structure the income," he said.

Finke commented: "I think that annuities are chronically underused in financial planning as a way of sheltering nonqualified tax-inefficient investments such as bonds."

In addition, "you may be able to get a tax arbitrage benefit if your client is in a lower marginal tax bracket environment in retirement, or if they move to a lower-tax state then," he said.

But whether your client chooses to buy a longevity annuity through a qualified or a taxable account, Finke and Blanchett agreed that it may not make sense to pay extra for an optional "return of premium" rider that gives back the premium, or some of it, to your beneficiaries if you die early. The rider cuts into the size of the annuity payments.

Blanchett suggested that it is best to think about longevity annuities as longevity insurance: "OK, just say, 'You know what? I'm going to buy this, and if I'm still alive in 20 or 25 or however many years, I'll get the income. If not, I'm not going to worry about it.' Right?"

Source: www.journalofaccountnacy.com