Use the Actuarial Approach and Our Spreadsheet to Address QLAC “Challenges”

Almost eighteen months after the IRS released final regulations on Qualified Longevity Annuity Contracts (QLACs), the market for these insurance products has become more robust, and retirement experts are becoming more aware of the potential advantages associated with QLACs.  See, for example, my post of November 24, 2015.   On the other hand, retirement experts and financial advisors are also discovering that integrating these products with a retiree’s withdrawals from accumulated savings can present some challenges.  I discussed the potential pluses and minuses of QLACs in my post of July 12, 2015.  Last month, The Stanford Center on Longevity, in coordination with the Society of Actuaries’ Committee on Post-Retirement Needs and Risks, published interim results of Phase 3 of their series on optimal retirement income solutions in DC plans entitled, “Using QLACs to Design Retirement Income Solutions.” This report correctly notes that buying QLACs complicates the spending budgeting process to some degree by introducing the potential for a discontinuity before and after the date that the QLAC payments are to commence (assumed to be age 85 in the report).  The report cites three key challenges for retirees and their advisors when buying QLACs:

• Determining the percentage of initial assets devoted to the QLAC. 
• Developing a SWP [Systematic Withdrawal Plan like the Actuarial Approach] withdrawal and asset allocation that minimizes disruptions in the amount of income between ages 84 and 85.
• Deciding whether the QLAC pays a death benefit before age 85, with the resulting drop in expected retirement income.

This post will discuss how these challenges can be addressed utilizing the Actuarial Approach and the “Excluding Social Security V 3.0” spreadsheet found in the “Articles and Spreadsheets” section of this website.   We will use Max, a 65-year old male retiree, to illustrate certain concepts.   At the beginning of the year, Max has accumulated savings in an IRA of $800,000 and an annual Social Security benefit of $20,000 per year.  To simplify the example, we are going to assume that Max uses the recommended assumptions to determine how much of his accumulated savings may be spent in his first year of retirement (i.e., he does not disaggregate his expenses into categories such as essential, non-essential, etc and use different assumptions or desired spending patterns for each spending category).  Under the recommended assumptions (and assuming no amounts to be left to heirs), he determines that $34,802 of his accumulated savings (4.35% of $800,000) may be spent during the first year, and therefore his total spending budget for the year, including Social Security, is $54,802 ($34,802 + $20,000).

Before he finalizes his spending budget for the year, he decides that he would like to see what the effect might be if he were to buy a QLAC with some of his IRA money.  So he goes to Immediateannuities.com and determines that if he pays an immediate premium of $100,000 he could receive a single life annuity commencing at age 85 of $4,406 per month ($52,872 per year) with no benefit payable to him or his heirs if he dies prior to age 85.  He then goes back to the spreadsheet on this website and enters $700,000 instead of $800,000 in accumulated savings ($800,000 – the $100,000 premium for the QLAC), $52,872 in Annual Deferred Annuity benefit to commence in the future and 21 as the Deferred Annuity commencement year.  All the other input items remain the same as above.  The spreadsheet tells him that $38,337 of his accumulated savings (5.48% of $700,000) may be spent during the year and his total spending budget would be $58,337 ($38,337 + $20,000 from Social Security, or about 6.5% higher than his spending budget without the QLAC).  He looks at the inflation-adjusted runout tab and sees that if all the assumptions are realized in the future (and inflation is 2.5% per annum), the sum of the withdrawal from savings plus the fixed dollar benefit from the QLAC is expected to be $38,337 in each of the next 30 years.  He also sees that his expected accumulated savings is only $85,184 at age 85 when payments from the QLAC are to commence as compared with inflation-adjusted assets of $319,524 at age 85 if he didn’t buy the QLAC.  Thus, while buying the QLAC can increase Max’s real dollar spending budget, it comes at the cost of increased spending from accumulated savings and therefore lower expected accumulated savings in later years, all things being equal.  Max also looks at the effect on his spending budget of starting his QLAC at age 80 rather than 85 and the effect of buying a QLAC with various death benefits, by inserting the different benefit amounts payable under different payment forms for a $100,000 premium from Immediateannuities.com.

Despite the possibility of having lower accumulated savings in later years, Max likes the increase in his real dollar spending budget that he can achieve with the single life QLAC with no death benefit payable starting at age 85, and decides to see what the effect would be if he paid $125,000 for a QLAC (the maximum under the IRS for Max under current regulations) rather than $100,000.  So he enters $675,000 in accumulated assets ($800,000 - $125,000), a $66,096 deferred annuity amount (from Immediateannuities.com) and 21 as the commencement year.  The program tell him that the “goal cannot be achieved”, which means that under the input assumptions, total constant dollar spending from withdrawals and the QLAC for the entire input period cannot be achieved (input accumulated savings are insufficient to meet the constant dollar spending goal).  Max has a number of options at this point, including living with a possibility that there will be a discontinuity in his real dollar spending budget at (or after) age 85.  For example, if he inputs 20 years for the “expected payout period”, zero deferred annuity and $675,000 of accumulated assets, he can expected, under the recommended assumptions to have an annual real dollar spending budget (not including Social Security) of $40,300 prior to age 85 and a fixed dollar benefit from the QLAC of $66,096 ($40,336 in real dollars at age 85 and decreasing thereafter, not including Social Security). 

So, let’s assume that Max chooses the no death benefit QLAC commencing at age 85 with the $100,000 premium.  Every year in the future, he will re-run the spreadsheet with new numbers and assumptions.  Depending on his actual investment experience, he could run into one or more years in which he sees “goal not achieved” if he suffers significant investment losses.  For example, if he inputs a -20% investment return in the first year of the 5-year projection (in the 5-year projection tab), he will see “value” which is equivalent in the 5 year projection tab to “goal not achieved.”  If this possibility is bothersome to Max, he has a number of alternatives, including choosing to buy a QLAC that pays lower benefits or investing his accumulated savings more conservatively to avoid significant losses.

I’ve used Max to illustrate how the Actuarial Approach and its simple spreadsheet can be used (along with QLAC quotes from Immediateannuities.com or from some other source) to address the three “challenges” associated with buying QLACs described above.  The authors at The Stanford Center on Longevity state that “Integrated SWP/QLAC strategies are ‘easier said than done’.”  I agree.  However, if you like the basic concept of a QLAC, I encourage you to play with our spreadsheet to determine how much QLAC you may want to buy and to use the spreadsheet and the Actuarial Approach to coordinate your pre-and post QLAC commencement periods.  Almost all other systematic withdrawal approaches are not even in the same league as the Actuarial Approach in terms of effectively addressing the three challenges discussed in the Stanford/SoA interim paper.