Insure Against Running Out of Money in Retirement with a QLAC?
Transcript:
Hey guys, Mike Frontera here back with another Retirement Theory Video. You know one the fundamental challenges we face when we enter retirement is the risk of running out of money.
I mean think about it… in retirement, we are tasked with creating lifetime income for ourselves with little or no future employment. Instead we pull from our savings. And that savings has to cover our needs and wants, and unexpected expenses for the rest of our lives. Taking into account inflation of course. We also can’t say for certain how much long-term growth we’ll get out of those savings. And in case you hadn’t noticed over the past couple of months, every so often that pool of savings suddenly shrinks! So we take all of those unknowns and then add in the biggest one, which is since we don’t know how long we’ll live, we don’t know long we need that pool of money to last!
So in general what do we do to manage all of those variables? Well, of course we do our income, investment and tax planning, and all the things needed to maximize what we have. Ultimately though, if the primary goal is don’t run out of money, we really have to be conservative with what we spend. And for most of us that means living on less than we can afford to do just to take into account all of the uncertainties.
With those challenges in mind, the Treasury Department and the IRS teamed up in 2014 to create something called a Qualifying Longevity Annuity Contract, also known as a QLAC. And at its core it is an income insurance policy that covers longevity. And what it proposes to at least help solve is the risk that we deplete our pool of savings because we live a long time.
So how does a QLAC actually work, and how you might use one to reduce that risk of outlasting your portfolio?
When you buy a QLAC, you take a sum of retirement money (IRA, 401(k), 403(b), etc.) and give it to an insurance company in exchange for stream of income that starts at some point in the future. For example, you may buy a QLAC at age 65 that starts paying income once you reach age 85. 85 by the way, is the latest you can defer income on a QLAC. Of course, the longer you defer, the more income you can get.
The primary benefit of the QLAC is that the income continues for the rest of your life, no matter how long you live. Very similar to a pension. The lifetime payments are guaranteed by the insurance company providing the QLAC. That brings up an important point, which is you need to look at the financial strength of the insurance company issuing the QLAC. As all benefits are based on the claims-paying ability of the insurer.
Your investment into a QLAC is limited by the IRS to the smaller of $135,000 or 25% of your total retirement plan or IRA balance. That limit is reviewed each year and has gone up slightly over time. Why the limit? One major reason is that you avoid Required Minimum Distributions on any money allocated to a QLAC. So if you had $500,000 in an IRA and invested $125,000 into a QLAC at age 72, you would only need to take RMDs on the remaining $375,000.
Another key aspect of the QLAC is that it isn’t invested in the market, so your future income is not affected by market fluctuations. That can cut both ways however, as this becomes akin to a fixed interest type of product. And with interest rates being low right now, there is a reasonable concern that you may not get much bang for your buck.
The biggest way that the QLAC can make up for that though is through mortality credits. Mortality credits is a term used by actuaries who help create these products that are based on life expectancy. If I have a large pool of people, an insurance company can reasonably estimate how long those people can expect to live on average. Those who live less than that average help fund a larger benefit for those who live longer than average. This is the basis behind mortality credits and it is a phenomenon unique to pensions and annuities. And if we’re looking to protect against longevity risk and running out of money, these mortality credits can be pretty powerful.
Let’s take a look at an example:
I ran a request for a QLAC quote on immediateannuities.com for a man age 60, looking for income to start at age 85. With a $120,000 deposit, New York Life shows an income of $49,536 per year. Should that man live to 95 and collect 10 payments, his rate of return would be 6.32%. The flip side however, is that had that man died prior to age 85 he nor his beneficiaries would receive anything. The full $120,000 would be lost.
There are other payout options though that would allow some protection against dying early as well. QLACs can offer payments to a beneficiary as well as a cash refund of all premiums to ensure that you or your heirs would at least receive what you deposited into the QLAC. There’s also cost of living adjustment or inflation riders that can be added to ensure your purchasing power is maintained. All of these options of course however will lower the income that can be had from the same amount of premium. The cash refund option in the example above, would pay the man and his beneficiaries at least $120,000. However, his quoted income payment from New York Life at age 85 would be lowered from $49,536 to $37,692. So you really need to weigh out payout options if you start going this route and know what you’re looking to cover. Bottom line though, a QLAC’s power comes from being able to take an unknowable income planning time frame and shorten it to a defined number of year. Think about entering retirement at 65 and be able to say, “hey if I can cover the next 20 years, I’ve got this other substantial income stream that will cover me beyond that point”.
If all of that sounds appealing, then let me just temper your enthusiasm once more with a final caveat. That is, once you decide to put money into a QLAC, that decision is irrevocable. The lump sum of money has been literally exchanged for a future stream of income. Beyond that future stream, and a possible death benefit, the money is gone. There are no withdrawal privileges, and there are no do overs. So while a QLAC can provide some powerful longevity protection and may even help simplify your retirement planning, it’s a commitment.
So! Do you have questions for me? Let me know. Come visit me at www.retirementtheory.com or send me an email at mikefrontera@retirementtheory.com. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning.
Once again, thank you for joining me, take care of yourselves, and we’ll see you next time!
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