An old adage in financial planning is that an individual has two great risks in accumulating wealth: Dying too young prevents adequate time to create a large estate. Living too long could cause the money to run out.
This article focuses on the second risk. Since many professionals have the bulk of their liquid assets in qualified plans or IRAs, we will use the IRA for illustration purposes.
Dr. Paull, who is age 70, has $3,000,000 in his IRA. Mrs. Paull is also age 70. Dr. Paull understands that next year he will need to commence distributions from his IRA under the Required Minimum Distribution (‘RMD”) rules. In year 1, he will be required to take out 3.77 percent of his IRA value as of December 31st of the prior year or $113,100, assuming the value remained at $3,000,000. Each year the rate of distribution increases with the assets revalued as of the December 31st of the prior year. At age 75, it is 4.37 percent and age 80, it is 5.35 percent. At a certain point, more is going out than being earned with the result that the balance declines. This usually starts to happen around age 80. Depending how well the investments do and how long the Paulls live, they may have enough money to maintain their lifestyle. But maybe not!
What if either of them live to age 95? At that point, the remainder of their IRA will be totally inadequate.
The U.S. Government was concerned that with increasing longevity, many older retirees, even those who started out with substantial nest eggs, would outlive their money.
In response to this dilemma, the Treasury Department, through Income Tax Regulations, now permit a Qualified Longevity Annuity Contract or “QLAC” to be purchased in limited amounts from an IRA. Here is how it works.
Up to 25 percent of the assets in the IRA to a maximum of $125,000 can be invested in a QLAC. No payments are made until the IRA owner reaches a preselected age, which could be as late as age 85. Once that age is reached, the payments commence and thereafter continue, for as long as the IRA owner lives. Optionally, it can be based on the life of the IRA owner and his or her spouse and payments can continue for as long as either of them are living. The amount of the payment is determined by contract with the insurance company.
Importantly, the money invested in a QLAC is not part of the asset value that is used to determine the RMD. Thus the required initial payouts on the IRA will be lower.
In order to maximize the payout to hedge the risk of living too long and outliving their money, the Paulls chose to invest $125,000 in a QLAC starting when Dr. Paull obtains age 85. This will pay him $4,354 per month for the rest of his life. If Dr. Paull were to die before then, there is no payout and the investment is lost.
Since many people are understandably uncomfortable with this scenario, the IRS permits certain guarantees to reduce the risk. One option is to provide that the minimum amount that can be received from the QLAC is the original investment. Thus, if Dr. Paull were to die before obtaining 85, all $125,000 is refunded. If Dr. were to die after obtaining age 85, but before receiving $125,000, the shortfall is refunded. This is known as the “refund option.”
However, this feature significantly reduces the payout and may defeat the purpose for which the QLAC was purchased, to provide significant retirement dollars should the individual live too long.
To understand the economics, recall that the $125,000 invested through Dr. Paull’s IRA at age 70 will provide a monthly payment starting at his age 85 of $4,354 for the rest of his life. If Dr. Paull had chosen the refund option described above, the monthly payout drops to $2,948. This is around 32 percent less.
While we can debate the economics and compute the internal rate of return based upon multiple scenarios, the purpose of the QLAC is to provide protection against outliving your retirement nest egg. To that extent, it performs well.