This article originally ran on July 22, 2014.
By Michael Webb, TGPC, AIF, CEBS
In a recent NTSA article, John Iekel outlined recently released IRS final regulations that permit longevity annuities in retirement plans and IRAs, and the Department of the Treasury promoted the development in a press release as part of an ongoing effort with the Department of Labor to encourage lifetime income and enhance retirement security. But will this guidance actually change participant behaviors? Or is it much ado about nothing? In this article, we will discuss the use of longevity annuities in 403(b) and other retirement plans and examine the potential impact of the IRS guidance.
What in the World Is a Longevity Annuity Contract?
Yes, since I am writing an article on longevity annuity options in retirement plans, I do indeed know the answer to this question! However, the reason that I pose it is that it is most likely a question that plan participants and sponsors would pose if they read the IRS guidance.
A longevity annuity contract (LAC) is an annuity that begins payments at an advanced age, that is often decades after the annuity is purchased (for example, an annuity that is purchased at age 65, but where payments do not commence until a participant turns 85). This is quite different than the more typical type of retirement plan annuitization option, which is a single-premium deferred annuity, where an account balance or portion thereof is used to provide a stream of income payments that commences immediately. LACs have been available for some time now, but as a practitioner who primarily works with ERISA 403(b) plans, I have rarely seen such contracts — which is why the plan sponsor and participants with whom I work are likely to ask the aforementioned question.
One reason for the rarity of such annuity contracts is the minimum distribution requirements under Code Section 401(a)(9). If I purchase an annuity that commences payments at age 85, and I retire before that age, I must commence minimum distributions from an annuity contact which, unfortunately, prohibits such distributions before age 85. Thus, I am unable to satisfy the minimum distribution requirements from later of age 70½ or retirement until age 85, incurring the draconian IRS penalty of 50% of the amount that is not withdrawn each year. Needless to say, this is not a pleasant outcome!
However, the final regulations address this issue by creating a Qualified Longevity Annuity Contract (QLAC), where an annuity will not be subject to the normal penalties for a missed required minimum distribution (RMD), if the following requirements are met:
- No more than 25% of a participant’s account balance or $125,000, whichever is less is used to purchase the QLAC;
- Payments must commence no later than the month following the participant’s 85th birthday;
- The annuity does not contain any cash surrender value or allow commutation (cessation of the annuity and distribution of the remaining values from the contract);
- The annuity is not a variable or equity-indexed annuity (i.e. payments must be fixed); and
- The annuity only permits certain types of death benefits, as described in the regulations.
Thus, it will now be more practical to provide longevity annuity contracts in retirement plans, and I can imagine that we can expect product providers to market such benefits to 403(b), governmental 457(b) (457(b) plans of private tax-exempts may NOT have QLACs) and other retirement plan sponsors.
- Practice Pointer: Explaining a longevity annuity to plan participants, or even plan sponsors, may be the retirement plan equivalent of rocket science. Thus, using simple terms, and explaining the basics of what an annuity is designed to do in the first place, should be a good place to start.
Will Participants Purchase QLACs?
Though some commentators seem to believe that QLACs will take the world of retirement plans by storm, especially when the Department of Labor finalizes participant statement requirements for lifetime retirement income projections, I, for one, find that much of an increase in QLAC usage difficult to fathom. QLACs clearly would be a viable option for someone who has limited need for immediate retirement income and wishes to preserve retirement plan assets, or for someone who simply wishes to lock in an income payment stream at later ages that would be far greater that normally be possible under conventional annuity options (due to the time value of money and increased mortality factors); however, the vast majority of participants have enough difficulty accumulating sufficient retirement income in the first place, never mind enjoying the luxury of having so much retirement income that they can postpone payment of a portion of their benefit for many years.
Secondly, though conventional annuity options that provide an immediate stream of payments at retirement are available in the vast majority of 403(b) retirement plans (any retirement plan with a 403(b)(1) fixed or variable annuity investment option), in my experience very few participants actually annuitize. The vast majority of participants take lump-sum distributions, partial payments, or withdraw funds as needed. Thus, if annuitization options that provided for immediate income are far from popular, why does anyone believe that annuities that provide for delayed payment will be prevalent?
Finally, the concept of annuitization is far too complicated for many participants to grasp. Studies have shown that most plan participants have little retirement plan literacy even regarding the basics. And annuities are FAR from a basic concept; I try to explain to participants that an annuity is basically a retirement plan version of the Social Security income they receive, but even then, their eyes begin to glaze over...
And for the few participants who do grasp annuity concepts, they are often confused between annuity investment options (such as 403(b)(1) fixed or variable annuities) and the actual annuitization of their retirement plan benefit. Throw in the unique complexities of longevity annuities, and it all adds to a scenario that does not suggest rampant utilization.
Though it is encouraging that, thanks to the IRS, longevity annuity options will now be viable in 403(b) and other retirement plans, it is difficult to envision long lines of participants waiting to be among the first to purchase such products. Of course, until such products are widely available in retirement plans, utilization remains a matter of speculation, though the lackluster history of utilization of retirement plan annuitization options in general can serve as a guide.
- Practice Pointer: As the IRS and DOL move forward with their joint initiative to promote lifetime retirement income, it might benefit advisors in their plan sponsor relationships to become a scholar of annuitization and other retirement income issues, even though actual utilization of products such as longevity annuities may remain low.
Michael Webb is the NTSAA Education Committee Co-Chair and a Vice President at Cammack Retirement.
Cammack Retirement is an independent retirement plan consulting firm specializing in non-profit industries. Offering tailored, actionable solutions, to help clients achieve the greatest return on their employee investment, Cammack Retirement delivers end-to-end solutions for complex retirement plan challenges.
Please note that this article is for general informational purposes only, is not intended to be taken as legal advice or a recommended course of action in any given situation. Readers should consult their own legal advisor before taking any actions suggested in this article.