One of the hardest risks to manage in retirement is the uncertainty of longevity: How long the retiree will live, and therefore how long of a time horizon needs to be planned for. Planning too short can lead to asset depletion if the retiree lives longer. Planning for too long leads the retiree to unnecessarily constrain retirement spending for a future that never occurs.
A special type of annuity is designed to address this problem. Longevity insurance is a deferred-income annuity, in which a person pays a lump-sum premium to an insurer in exchange for a guaranteed lifetime income stream that begins several years later--perhaps well into the person's 70s or 80s. Until tax law changed over the past few years, these annuities could not be widely used in 401(k) retirement plans and IRAs because those plans require account holders to begin withdrawals at age 70½.
Workers can now satisfy those rules if they use a portion of their retirement money to buy the annuities and begin collecting the income by age 85. Anyone with defined contribution plans such as 401(k) and traditional IRAs is allowed to circumvent the Required Minimum Distribution (RMD) rules up to the lesser of $125,000 or 25 percent of their retirement plan balance, to the extent that it's invested in "qualifying longevity annuity contracts" (QLACs). A key requirement is that QLACs provide that lifetime distributions begin at a specified date no later than age 85. Someone with a $500,000 account balance, for instance, can buy the maximum amount.
The annuities must also be relatively basic and cannot be loaded up with many of the special features, like cash-surrender options, that insurers often offer. But annuity providers are permitted to sell a feature that guarantees that the annuity owner's beneficiaries will receive the premium amount originally paid, minus any payments already made. They can also provide an option that would continue paying the income to a beneficiary after the annuity owner's death.
Buying an annuity that doesn't begin making payments until much later is more cost-effective than buying an annuity at retirement and collecting the income immediately. The reason is straightforward: There is a higher chance the individual will not live long enough to begin collecting payments, and the money from people who die earlier benefits those who live longer.
For example, take a 68-year-old man who buys an income annuity and immediately begins collecting lifetime income of $1,000 a month, or $12,000 a year. His premium would be about $170,000, according to New York Life. But if the same man bought the annuity at age 58 and waited 20 years to collect his payments, he would pay less than $40,000 for the same $12,000 in annual income.
Given the fact that people are generally living longer, combined with the uncertainty of the sustainability of a traditional investment portfolio as a source of retirement income, a QLAC can be a welcome option.