Combining Investments with Insurance in Retirement

This post is a follow-up to our post of June 18 entitled, “Managing Risks in Retirement through Diversification of Retirement Income Sources.”  The impetus for this post is another excellent article by Dr. Wade Pfau entitled, Evaluating Investments versus Insurance in Retirement, featured in the June 30, 2015 edition of Advisor Perspectives.  And while Dr. Pfau does a fine job of presenting the advantages and disadvantages of exclusively using either investments or insurance to fund retirement, his primary purpose is to advocate combining the two approaches in retirement.  He concludes that “retirement income planning is not an either/or proposition” and “the risk pooling features of insurance and the upside potential of stocks make for an effective combination for retirement income.”  As this combining of retirement income sources has been a pretty consistent theme of this website for quite a while, I will take this opportunity to once again point out how intelligent Dr. Pfau is. 

Of course it would have been nice if Dr. Pfau had been a bit more specific with regard to his recommendations regarding 1) proportions of each type of investment 2) timing of annuity purchases or 3) types of annuity purchases (immediate annuities or deferred income annuities, QLACs).  But perhaps these recommendations will be forthcoming soon from the eminent retirement researcher. 

As emphasized on our June 18 post, the Actuarial Approach advocated in this website is one a very few approaches that actually attempts to coordinate fixed dollar insurance annuities (or pensions) with withdrawals from investments when developing a retiree’s spending budget.  Most other approaches assume a 100% investment approach (and/or simply ignore the existence of annuities/pensions).   If a combined fixed immediate annuity (or pension)/investment approach is used, the withdrawal strategy needs to do double duty.  Withdrawals from investments must not only provide supplementary lifetime income with desired cost-of-living increases on such income, but must also provide for desired cost-of-living increases on the fixed dollar annuity.   If a combined deferred income annuity (QLAC)/investment approach is used, withdrawals from investments must work even harder.  Such withdrawals will be the sole source of income prior to commencement of the deferred annuity (together with desired cost-of-living increases).  After commencement of the deferred annuity, withdrawals from investments need to provide supplementary income (together with desired cost-of-living increases on such income) as well as desired cost-of-living increases on the fixed dollar deferred annuity income.  But don’t worry.  Unlike the many other commonly-advocated withdrawal strategies, the Actuarial Approach does all this coordination for you automatically.

Pluses and Minuses of Buying Longevity Insurance (QLACs)

Ever since the IRS published proposed regulations permitting Qualified Longevity Annuity Contracts (QLACs) in early 2012, I have encouraged my readers to consider these products in combination with withdrawals from their managed assets as a way to manage their longevity risk. 

The market for these insurance products has become more robust as more insurance companies are coming out with QLAC products.  The question remains, however, as to whether now is a good time to buy a QLAC or would it be better to wait (or perhaps never buy one).  This post will provide a brief background on QLACs and will outline some of the pluses and minuses of buying one.   In addition, I will also touch on the separate decision of whether it makes sense to buy one now in today’s economic environment, or possibly wait.  Since I don’t recommend investments, you won’t see a recommendation here—just things to consider.

Background

A QLAC is a deferred income annuity payable from a qualified defined contribution plan or IRA that is purchased from an insurance company with lifetime benefits (generally paid monthly) commencing no later than age 85 that meets various IRS requirements.  The IRS final regulations on QLACs contain lots of rules (that I will not go into here) regarding how these deferred income annuities “qualify” as QLACs for special treatment under the Required Minimum Distribution rules.     For this post, I’m going to focus on a simple version of the QLAC that I refer to as a “pure longevity insurance” QLAC.  Under this QLAC, a retiree buys a deferred income annuity (with a single premium) using funds from her IRA with monthly lifetime annuity benefits commencing at age 85 and no death benefits payable if she dies either before or after commencing benefits.  According to Immediateannuities.com, a single premium of $70,000 today will buy a 65-year old male a lifetime monthly income of $2,882 commencing at age 85.  By comparison, the single premium required to purchase that level of monthly income commencing at age 65 would be about $516,000.  Because females generally live longer than males, premiums are higher for age 65 year old females to buy the same levels of income.  If annuity purchase rates remain unchanged in the future (highly unlikely), waiting to purchase a QLAC that commences at age 85 will raise the premium.  For example, it would cost a 70-year old male about $82,750 (as compared with the $70,000 premium for the 65-year old) to obtain the same lifetime monthly income of $2,882 commencing at age 85.  There are two reasons for this:  1) the insurance company will have 5 fewer years to invest the premium and 2) it won’t have the “risk pooling” premium that would have been available if the retiree had bought the premium at age 65 and died before age 70. 

I used the term “pure longevity insurance” for the QLAC described above.  It is similar in concept to buying term life insurance or buying fire insurance.  It pays essentially nothing if you don’t experience the contingency you are buying the insurance for.  If you don’t have a fire, you will receive no payment from your fire insurance.  Your premiums will be “pooled” and used to pay the fire damage claims of others who do have fire damage.  Similarly, with pure longevity insurance, you will receive payments if you live past age 85 and nothing if you die prior to age 85.  If you live significantly past age 85, you will benefit from the same type of insurance pooling that fire victims receive when they have fire damage.  For some reason, people who have no problem at all with buying fire insurance or term life insurance don’t like the concept when it comes to longevity insurance. 

Some Pluses of QLACs

1. More efficient than self-funding.  As I recommend in this website, if you are going to self-insure your retirement through strategic withdrawals from your accumulated savings, you are going to have to plan to live longer than your life expectancy.  In this website, I recommend that you plan on living until age 95 (which is longer than your life expectancy until you get to around age 90).  If you plan on living until age 95 and the insurance company assumes that you live until your life expectancy when pricing the QLAC, it will be less expensive for you to buy the QLAC to cover those last 10 years (and beyond) than to self-insure (unless you believe the risk-adjusted return on your investments will beat the QLAC investment return including risk pooling benefits).  See my post of May 28, 2015 for a numerical example of the impact of purchasing a QLAC on a retiree’s spending budget. 
2. Less expensive than immediate annuities.  As noted above, the premium required under a QLAC is much less than under a single premium immediate annuity, but the amount of longevity insurance is approximately the same.  Because it is cheaper, the QLAC gives the retiree more investment opportunity and more flexibility. 
3. Reduces investment responsibilities in later life.  Some argue that those of us who reach 85 and later years may not have the mental capacity to manage our investments appropriately.  In this respect, the QLAC provides guaranteed income at a time when needed the most.
4. Provides assurance that a retiree won’t run out of money (assuming they make it until age 85).
5. Can reduce the size of a retiree's account that is subject to Required Minimum Distributions and therefore defer payment of related income taxes.  

Some Minuses of QLACs

1. Insurance company profit.  Insurance companies are in the business of making money.  In addition to building a profit into their premiums, they will assume that most individuals who are confident enough to purchase longevity insurance will probably live longer than average.  These factors will eat into the risk pooling benefit discussed above to some degree. 
2. Inflation.  Like most annuities sold today, QLACs generally pay a fixed dollar amount per month.  Inflation will erode the value of such benefits.  Depending on future inflation, the value of a benefit commencing twenty years from now may not be adequate to meet living expenses. 
3. May not be easy to coordinate withdrawal strategy from invested assets with benefits anticipated under the QLAC.  If a retiree desires to meet essential expenses with level real dollar spending over a 30 year period (for example from age 65 to age 95), withdrawals for the first 20 years need to be such that they increase each year with inflation and then in the 20th year, smoothly glide into the QLAC income (no big jumps or decreases) and for years 21-30 withdrawals need to cover any shortfall in the QLAC income and provide for inflation increases.  [Note that this coordination is one of the strengths of the Actuarial Approach advocated in this website that you won’t find elsewhere]
4. Some retirees don’t like the idea that they may get nothing but insurance from a QLAC.
5. Increased investment responsibility compared with immediate annuity.  The retiree is on the hook for managing money for at least until age 85.  Unlike with an immediate annuity, there is no guaranteed income prior to age 85 and the retiree could run out of money prior to age 85.

Is Now a Good Time to Buy a QLAC?

Investment underlying annuity contracts are essentially bond investments and for QLACs, long bond investments.  If you believe that long-term interest rates and long-bond yields will rise significantly in the future, then it is probably best to wait to buy a QLAC.  On the other hand, as noted above, the longer you wait, the less income you will receive from a given level of premium if interest rates remain unchanged.  An alternative strategy to buying a QLAC that still involves significant longevity risk pooling benefits is to simply wait until an older age to buy an immediate annuity.