Unlike life insurance, which provides financial protection against dying a premature death, an annuity provides protection against living too long. Thus, an annuity is insurance designed to provide for the possibility of an individual or retiree outliving his or her income, known in insurance language as the risk of “superannuation”. An annuity product’s inclusion as a payment option in an employer-sponsored retirement plan has been encouraged by recent legislation. Essentially, any employer plan must include an illustration of what an annuity payout would look like if the participant chose to “annuitize” his or her retirement income distribution.

Annuitization is the process of converting an accumulated capital sum, usually at the date of retirement, into a level and regular stream of annual payments. The process is designed to eliminate what is known as “longevity risk” or the “risk of superannuation”, the possibility of outliving one’s money and not dying until after one’s projected life expectancy. An annuity to begin payment after the date of retirement is an “immediate annuity” used in the process of “immediate annuitization”. Often, an employer-sponsor of a retirement plan, particularly a pension plan, will purchase a commercial annuity with the accrued benefits of the plan, thereby transferring the risk of future retiree payments to an insurance company. The default risk associated with non-payment is, as a result, transferred from the balance sheet of an employer to the balance sheet of the insurance company.

Despite the obvious advantage of the immediate annuity in the elimination of longevity risk, most Americans have traditionally not favored the annuity product and process of immediate annuitization. Why? The primary reason for rejecting the form of payment is the loss of control over the retirement assets. Specifically, the “annuitant” (person entitled to the annuity payments) may require a considerable sum of retirement funds to pay for a medical emergency. Whereas annuities often provide for a “guaranteed lifetime withdrawal benefit” (GLWB) of a percentage of funds (for example, five percent of the income base) as an alternative to annuitization, this may not be adequate to meet the financial needs of the annuitant. Annuities sold-in-the-past specified the forfeiture of the capital sum (the “principal”) of the annuity if the annuitant died before collecting the total sum. This has now been remedied by present-day annuities where a death benefit is offered to a named beneficiary. Indeed, a special form of annuity payment option, a “qualified joint and survivor annuity” (QJSA), must be offered to some married participants of an employer-sponsored plan. If a plan requires a QJSA, a married participant opting for a single-life payout of the retirement assets at the time of distribution, must get the written consent of a named beneficiary to waive the joint form of payout.

Other perceived problems with the immediate annuity form include:1) if fixed in amounts payable (as is usually the case), such payments are not adjusted for inflation; and 2) low interest rates (as is currently the case) will lower the amount of payment. Still, the immediate fixed annuity form is often purchased to protect against the possibility of a “bear market” in stocks; that is, such annuity purchased by the retiree will typically cover his or her basic living expenses so that stocks do not need to be sold at a potential loss and reduce the growth of the retiree’s portfolio. For this reason, as well as to implement portfolio diversification, most financial advisors recommend that no more than half, usually less, of a retiree’s investment portfolio consist of an immediate (or variable) annuity.

Annuities may be categorized in several ways, but most investment advisors differentiate annuities by the time and method of payment: an immediate fixed or deferred variable annuity. An immediate fixed annuity makes payments immediately, or within one month from the purchase date of the annuity, and in a fixed or pre-determined amount. Such an annuity is often used by a retiree as an alternative to a reverse mortgage and tends to be “qualified” for tax purposes, meaning all annuity payments are currently taxable (since the annuity was purchased with “before-tax dollars”, either by an employer-sponsor of a retirement plan, or from a rollover IRA established by the annuitant). In contrast, a deferred variable annuity is purchased by a pre-retiree to provide variable payments at the time of the individual’s retirement date. As such, the pre-retiree may increase payments over time through the growth of the annuity’s account value in mutual fund sub-accounts. The variable form of annuity, for tax purposes, may be payable either from qualified funds (such as a rollover IRA) or non-qualified funds, where the “after-tax dollars” expended to purchase the annuity are recovered tax-free by the annuitant during the time of retirement. Both types of annuities provide for a death benefit to the heirs of the annuitant, a feature that is common to insurance products generally. But, unlike a traditional life insurance policy, the death benefit payable from an annuity is income-taxable!

Historically, annuities, particularly deferred variable annuities, have not been recommended by investment advisors because of the high cost of the annuity. The argument goes that a variable annuity is nothing more than a “mutual fund wrapped in a life insurance shell”! Thus, if wanting to invest in mutual funds, a retiree, particularly one that does not need life insurance protection, should merely invest in the mutual fund without the death benefit protection and cost. There are also additional costs incurred with the purchase of “riders” associated with most annuities. However, a major advantage of a deferred variable annuity is that the pre-retiree is permitted to save a large amount of cash and not pay taxes on either the cash or the income generated thereon until a much later date. The annuity can then be used as a supplement to Social Security and personal savings in generating needed retirement income. Moreover, to encourage the inclusion of an annuity as a source of retirement income, the SECURE (Setting Every Community Up for Retirement Enhancement) Act of 2019 made it easier for an employer to offer an annuity in a retirement plan without fear of employer liability for possible underperformance.

A final, and increasing-in-popularity, form of annuity is a deferred income annuity, a type of which was introduced by the Obama administration: the QLAC or qualified longevity annuity contract. A deferred income annuity is a type of insurance contract whereby, in exchange for a lump sum payment, the insurance company promises to make a monthly payment to an individual beginning at some future point of time. In such manner, the individual (known as “the annuitant”) is insured (guaranteed) against running out of money during his or her lifetime. The annuity payment can begin at any point in the annuitant’s future, including in his or her early 80’s when many long-term care payments are initially needed. Moreover, the assumed interest rate used to calculate the amount of deferred annuity income is generally higher than prevailing bank certificate-of-deposit (CD) or Treasury Bill rates.

A “qualified longevity annuity contract” (or “QLAC”) is a type of deferred income annuity funded with proceeds from a tax qualified retirement plan, such as a 401(k) plan or IRA. Under current law, an individual must begin “required minimum distributions” (or “RMDs”) no later than April 1st of the following the year in which he or she attains the age of 72. A QLAC is a retirement strategy whereby a portion of the RMD for the annuitant is deferred until a certain age (currently, the maximum is age 85). The main benefit of the QLAC is a deferral of taxes that is otherwise due on the RMD. The maximum age of 85, which may be chosen by the annuitant, also corresponds nicely to when the annuitant may need the RMD for the payment of long-term care expenses. Under current rules, an individual can expend the lesser of 25% or $135,000 of their employer-sponsored retirement plan or IRA to purchase a QLAC.

If you are interested in using an annuity as a source of retirement income in your portfolio, please contact either Willis or Nick of our office.