Retirement should be a time for relaxation, travel, and pursuing your passions. However, a nagging concern haunts many: they fear they will outlive their savings. After all, as lifespans increase, the traditional retirement game plan might not work. Half of non-retired Americans (51%) have concerns about outliving their retirement assets, according to the Schroders 2024 U.S. Retirement Survey.
In response to Americans’ fears of outliving their savings when they retire, longevity annuities may offer peace of mind. In this post, we will take a closer look at longevity annuities, how they work, their pros and cons, and whether they are suitable for your retirement strategy.
What Exactly is a Longevity Annuity?
Longevity annuities, or deferred income annuities, are contracts between you and an insurance company. In exchange for the payment, you receive a guaranteed income stream starting at some point in the future, typically in your 80s or older. It’s like an insurance policy against running out of money later in life.
Several factors determine how much income you will earn in the future;
- Your initial payment amount.
- The age at which you purchase the annuity.
- How long do you expect to live?
- The age at which you begin receiving payments.
It is important to note that income payments are unaffected by market fluctuations. Depending on your annuity’s terms, you might be able to make additional contributions, which will then adjust your income.
How Does a Longevity Annuity Actually Work?
A longevity annuity relies on the concept of pooled risk. Collecting premiums from many individuals, the insurance company creates a large pool of funds. In other words, some people will unfortunately die before they expect to, while others will live long, healthy lives.
A portion of the premiums from those who die earlier helps fund the payments for those who live longer. As a result of this pooling mechanism, insurance companies can offer higher payouts than you can achieve by investing the lump sum and withdrawing it over time.
Here is a step-by-step breakdown of the process;
- Purchase. The annuity can be purchased as a lump sum or a series of payments. The money for this can come from various sources, such as a traditional IRA, 401(k), or regular savings.
- Deferral period. This is the period between when you purchase the annuity and when your income payments begin. During this time, your money grows tax-deferred. Although the insurance company invests the pooled funds, your annuity growth is not directly tied to market performance, such as a variable annuity. In general, it’s about how the insurance company invests its money.
- Income commencement. Your guaranteed income stream begins when you reach a certain age, often between 80 and 85. In most cases, you’ll receive lifelong payments.
- Payout options. Usually, you have several payout options. In a single-life annuity, payments continue only until the time of your death. Alternatively, a joint and survivor annuity ensures that costs continue to your designated beneficiary (usually your spouse) after your death. Joint and survivor annuities are typically cheaper than single-life annuities, but their monthly payments are typically higher.
Longevity Annuities vs. Immediate Annuities: What’s the Difference?
While longevity and immediate annuities guarantee lifetime income, they are purchased with premium payments and serve different needs.
- Premium payments. Often, longevity annuities allow for either a single lump-sum payment or periodic payments. In contrast, immediate annuities require a single lump-sum payment.
- Start of payouts. Longevity annuities are designed so that income starts at a future date you choose. Almost immediately after purchase, immediate annuities begin providing income.
- Crediting rates. There are three types of immediate annuities: fixed, fixed-indexed, and variable, which means their payments fluctuate based on market conditions. Generally, longevity annuities have fixed interest rates, making their income more predictable.
Due to these differences, each type of annuity is suitable for a different situation. When you have substantial money available right now, immediate annuities are often the best option. In general, longevity annuities are best for people further from retirement who don’t have much money to invest at once.
Qualified vs. Non-Qualified Longevity Annuities: The Tax Angle
The two main varieties of longevity annuities are qualified longevity annuity contracts (QLACs) and nonqualified ones. Taxation is the key difference between them.
- Qualified Longevity Annuities (QLACs). A QLAC is funded with money from qualified retirement accounts such as 401(k)s, pensions, or IRAs (traditional or Roth). Because you haven’t yet paid income taxes on this money, it is considered “qualified.” Although the money grows tax-deferred, you must still pay income taxes when you retire. There are some specific rules for QLACs. Contributions to QLACs are limited to $210,000 over a lifetime. Every qualified retirement account, including IRAs, is subject to this limit. In addition, you can only defer payments until you are 85 years old. However, they can be valuable tools for managing Required Minimum Distributions.
- Non-Qualified Longevity Annuities. You can fund these annuities with money you have already paid taxes on. As such, that principal won’t be taxed again; only the earnings will be. In addition to being structured as joint annuities, non-qualified longevity annuities may include cost-of-living adjustments (COLAs) and even offer a return of premiums. However, these add-ons usually have a cost.
The Upsides: Why Choose a Longevity Annuity?
Longevity annuities provide several compelling benefits;
- Protection against outliving savings. This is the most crucial benefit. A guaranteed income stream provides a safety net if you run out of money in retirement.
- Predictable income. When you know how much you’ll receive and when you’ll receive it, retirement budgeting becomes much easier.
- Tax deferral. You don’t pay taxes on the earnings until you receive income from your annuity, so your money grows tax-deferred.
- Potential for higher payouts. As a result of their pooled risk nature, these annuities are likely to pay out more than you might be able to achieve on your own.
- Peace of mind. A guaranteed future income stream can significantly reduce financial stress and give you greater peace of mind.
- QLAC advantages. As an added benefit, QLACs may delay RMDs, providing additional tax advantages.
The Downsides: What to Consider
It should be noted, however, that longevity annuities also have some drawbacks;
- Illiquidity. An annuity’s principal can’t usually be accessed once you’ve bought it. As a result, you should only use funds you are confident you won’t need before your income payments begin.
- Inflation risk. Over time, fixed-income payments may not keep up with inflation, decreasing purchasing power. Although some annuities offer inflation adjustments, these usually result in lower initial costs.
- Opportunity cost. If you lock your money into a longevity annuity, you might miss out on potential gains from other investments.
- Mortality risk. Depending on the contract, if you die before the income payments begin, you or your beneficiary may receive less than you paid for the annuity. In some annuities, there is an option to return the premium. However, this will result in a decrease in future income payments.
- Complexity. Longevity annuities can be complex, containing many options and features. Understanding the terms and conditions before you make a purchase is essential.
- Insurance company risk. While rare, an insurance company can default. For this reason, an insurer’s financial stability and reputation are critical factors in your decision.
Is a Longevity Annuity Right for You?
In terms of longevity annuities, there is no one-size-fits-all solution. Generally, they are best suited to those who;
- Are concerned about outliving their savings.
- Have other sources of retirement income.
- Feel comfortable with illiquidity.
- Recognize and accept inflation risks.
- Understand the terms and conditions completely.
Before You Buy: Do Your Homework
If you believe you are a good candidate for a longevity annuity, make sure you conduct your due diligence by;
- Consult a financial advisor. A qualified advisor can help determine whether a longevity annuity suits your situation.
- Shop around and compare quotes. Insurers have different rates and features, so always check multiple companies for quotes.
- Read the contract carefully and understand all the terms, including payout options, fees, and surrender charges.
- Consider your overall retirement plan. The purchase of a longevity annuity should be incorporated into your retirement strategy.
Conclusion
If you are concerned about outliving your savings, longevity annuities can be a valuable tool. There are, however, both advantages and disadvantages to these products. Before deciding, understand the terms and conditions and consult a financial advisor. When carefully evaluating your options, you can determine if a longevity annuity will help you achieve a secure and comfortable retirement.
FAQs
What is a longevity annuity?
A longevity annuity is a contract between you and an insurance company. You pay a lump sum premium now (or sometimes a series of payments), and the insurance company promises to pay you a guaranteed income stream starting at a future date. In most cases, this date is several years or even decades in the future.
Who should consider a longevity annuity?
- Individuals with a high probability of longevity, those whose families have a history of long lives or excellent health, may benefit most.
- Those with sufficient other retirement savings. You should consider longevity annuities as part of your retirement plan, not as the only source of income.
- People seeking guaranteed income later in life. Regarding security and predictability, a longevity annuity may be appealing.
How much does a longevity annuity cost?
A longevity annuity’s price can vary depending on several factors, such as;
- Age. Generally, the lower the cost of a longevity annuity, the younger you are when you purchase one.
- Lump-sum payment. Usually, the greater the lump-sum payment, the greater will be the cost.
- Payout period. The cost will likely increase as the payout period extends.
- Interest rates can affect the cost of a longevity annuity. At low interest rates, longevity annuities are more affordable.
- Company. Annuities with longevity rates vary from one company to another. Getting quotes from multiple companies is essential before making a decision.
How do I choose a longevity annuity?
- Get quotes from several insurers and compare them.
- Be familiar with the contract’s terms and conditions.
- Evaluate the insurance company’s financial strength. AM Best, Fitch, Moody’s, and S&P Global are U.S. credit rating agencies that evaluate insurers’ financial strength. Each agency has its own rating standards.
- Speak with a financial advisor to determine if a longevity annuity suits you.
Are longevity annuities insured?
Typically, longevity annuities are backed by the financial strength of the issuing company. Some states also have insurance guaranty associations, but their protection varies by state. However, the FDIC does not insure longevity annuities since they aren’t bank deposits.
Do I have to pay taxes on the income from a longevity annuity?
Yes, you will have to pay taxes on the income from a longevity annuity. In either case, the income is taxed differently depending on whether the annuity is qualified or nonqualified.
- Qualified annuities are funded with pre-tax dollars, such as those in 401(k)s or IRAs. You are taxed on ordinary income when you withdraw money from a qualified annuity.
- A nonqualified annuity is funded with after-tax dollars. Your earnings on a nonqualified annuity are taxed as ordinary income, but your principal is not.
You should know that your annuity may be subject to other taxes and penalties, such as a 10% penalty for early withdrawals.
If you have any questions about the specific tax implications of your annuity, you should speak with a tax advisor.
