The Treasury Department and the Internal Revenue Service gave people saving for retirement a nice present just before the July 4 celebration by changing the tax treatment of deferred-income annuities.
The new tax treatment makes deferred-income annuities — also called longevity annuities — more acceptable as a retirement option because it excludes the value of such annuities from the retirement account balances used to determine required minimum distributions.
Previously, the account balances were included in the calculation of the required minimum distribution at 701/2, even though annuity holders did not begin receiving income from them until a later age, such as 80.
Now, savers in a 401(k) plan or individual retirement account can use up to 25% of their account balance, or $125,000, whichever is less, to buy qualified longevity annuities.
Deferred-income annuities can alleviate retirees' fears of running out of money late in life, but they are not for everyone, and investment advisers and financial planners should be prepared to advise clients and help them select the best available annuities, if appropriate.
This ruling will no doubt give insurance companies in-centives to step up their efforts to sell more longevity annuities. Advisers should make sure they are up to speed on the various annuities being offered, their prices and conditions as well as the terms of the new IRS rules. They should also look at the commissions on sales of these annuities to make sure they are reasonable.
Then advisers should get ahead of the game by talking to those clients who might be prime targets of these sales efforts — those who have accumulated substantial 401(k) or IRA balances and are thus able to afford a significant longevity annuity — and educating them about the pros and cons of these annuities.
The key advantage is obvious: The purchaser will never outlive the income from the annuity, which will always be there to supplement Social Security, no matter what happens to his or her other retirement income streams.
Another advantage is that by deferring receipt of income from an annuity, a purchaser can buy the income stream for much less than he or she would pay for the same stream from an immediate fixed annuity.
There are several disadvantages, however, that must be considered. The key one is that the money used to buy the annuity is locked up until the deferral period is over — that is, it is an illiquid investment. While the implied return on the amount invested might be higher than most fixed-income alternatives, the investor might be better off in the long run keeping the money in a diversified portfolio.
Second, there is a chance the purchaser might not live long enough to collect the income stream, or long enough to recover the full value of the amount invested and the implied return on investment. A 50-year-old male buying a deferred annuity has a life expectancy of just over 29 years. Thus the average male buying such an annuity will die just as the annuity set to pay at age 80 is about to start its annual income distribution.
A 50-year-old woman can expect to live 33 years on average, so the longevity annuity might make more sense.
However, these life expectancy figures are averages, and as high-income earners — those who could most afford such annuities — generally have longer life expectancies than low-income earners, the annuities might make more sense for them.
Another disadvantage of the deferred annuity is that the income stream is not generally inflation-adjusted. If a purchaser buys an annuity promising an income stream of $1,250 a month to be received in 30 years, inflation likely will significantly erode the value of that monthly income before it is received.
Nevertheless, despite these issues, deferred income annuities might well be of interest and value to some clients approaching retirement, especially those who have enough retirement savings to afford the annuities and who are concerned about outliving their retirement income, perhaps because their families have strong longevity genes.
Financial advisers should help their clients examine these annuities and the issues they raise and decide if they are a suitable retirement investment vehicle.