Q: When I began my financial plan last year, my planner suggested that we assume I will live to be 95. My family isn't known for its longevity, so I told her that seemed a little ambitious. She also recommended that I purchase an annuity to protect myself against the risk of outliving my savings. My initial reaction was skepticism, as I had read elsewhere that annuities are a rip-off. What are your thoughts? Does an annuity make sense?
A: In general, I agree with your skepticism about annuities. They are typically heavy on fees and difficult for the lay person to fully understand—not the kind of investment a fiduciary would usually recommend. However, a certain type of annuity known as a Qualified Longevity Annuity Contract, or QLAC, may make sense in your situation. But before delving into QLACs, let's first talk about longevity risk.
Simply put, longevity risk is the risk of outliving your assets. Living longer than expected may seem like a "first world" problem to most of us, but outliving your assets is a serious problem. When doing your financial planning, it is critical that you consider your expected life span. Conservative estimates (i.e., planning for a longer life) are preferable in my opinion. Nobody wants to be old and impoverished.
Several studies have found that people, on average, underestimate their own life expectancy. According to the Stanford Center on Longevity, two-thirds of pre-retiree men underestimate the life expectancy of the average 65-year-old man, while half of pre-retiree women underestimate the life expectancy of the average 65-year-old woman. According to a separate survey conducted by the Society of Actuaries, 79 percent of retirees believe their personal life expectancy is shorter than actuarial estimates, with more than half missing by more than five years.
Purchasing a Qualified Longevity Annuity Contract (QLAC) is one way to protect against longevity risk. A QLAC is a type of deferred income annuity that can be purchased through employer-sponsored retirement plans, such as 401(k) and 403(b) plans, or through a traditional IRA. With a QLAC, an insurance company promises to pay you a fixed monthly income for the rest of your life beginning at some point in the future in exchange for a lump sum payment today.
One of the most appealing aspects of QLACs is that money invested in a QLAC is exempt from required minimum distributions until the IRA owner begins receiving annuity payments. However, in order to receive this benefit, the annuity must meet a few specific criteria.
First, the annuity must be a fixed annuity, which means it must pay a fixed amount every month. Variable or index annuities are not permitted.
Second, annuity payments cannot begin before you reach the age of 72 and must begin no later than the month after you reach the age of 85.
Third, your lifetime QLAC premiums are limited to the lesser of 25% of the total value of your qualified retirement account balances (including existing QLAC purchases) or $135,000. The percentage limit for IRAs is calculated based on the total value of all your IRAs as of December 31 of the year preceding your premium payment. The limitation for employer-sponsored plans is calculated based on the last valuation date prior to the date of your premium payment. If all of this sounds confusing, you're not alone. Before buying a QLAC, you may want to consult with an advisor with QLAC experience.
You should be aware that once you put money into a QLAC, you are committed. You will not be paid prior to the contractual start date, and the amount of your payout will not change. QLAC payments can be set to end when the annuitant dies, when both the annuitant and the annuitant's spouse die, or for a set number of years, whether to the annuitant or the annuitant's heirs.
My final point about QLACs is that they are only one component of a well-developed financial plan. To determine if this is right for you, consider how it fits into the rest of your retirement strategy.
Steven C. Merrell MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to steve@montereypw.com.