The new kid on the block in the annuity world is the longevity annuity.

It was actually introduced in 2004, but it has just been in the past few years that this simplistic future income strategy has started to gain traction in the retirement income planning world. If you think you might need contractually guaranteed lifetime income that starts at a future date, then you need to know the details about this unique transfer-of-risk strategy.

Longevity annuities go by many names, and it seems like most financial journalists are confusing the issue with this lack of name uniformity. Longevity annuities have also been called:

• advanced delayed annuities,
• longevity insurance, and
• deferred income annuities (DIAs).

Regardless of which name is used, they are all the same simplistic future pension strategy that I predict will be the most popular type of annuity purchased within the next five years. Currently, the complex and high-agent-commission variable and indexed annuities represent the majority of annuities sold. The key word is “sold.”

Longevity annuities will lead the charge of consumers wanting simplistic and no-annual-fee designs with low agent commissions along with the ability to buy direct (which will also happen in the very near future).

That’s a pretty bold prediction for a product that currently represents less than 2% of all annuities sold, but I stand by this glimpse into the future because longevity annuities are so pro-consumer. At the end of the day, the customer always wins and always dictates product design and distribution. This evolution of the annuity industry is the next financial domino to fall.

There’s a lot of misinformation surrounding the longevity annuity product, so let’s take a look at how these future income strategies work and the ways they could possibly complement your portfolio.

Longevity Annuity Income Structures

If a longevity annuity had a first cousin, it would be a single-premium immediate annuity (SPIA). Just like an SPIA, a longevity annuity has no accumulation portion of the contract and is a pure transfer of risk that is designed to provide a guaranteed lifetime income stream. Longevity annuities and single-premium immediate annuities are pretty much structured the same way, with the primary difference being that SPIAs are for income now and longevity annuities are for income later.

There are many ways to structure the contractual payout of a longevity annuity, and you can customize the policy to meet your exact goals. Below are just a few ways to contractually structure the future income of a longevity annuity. Your agent and adviser should show you all of the options available and fully explain them so you can make an informed decision. The income structure choice is made at the time of application and cannot be changed after the policy is past the free-look period that is specific to each state. The free-look period is a provision that allows you to get out of a policy, within a specific time period, after the contract has been delivered.

Life With Period Certain

This structure guarantees a lifetime payment, but the period certain part of the contract provides a minimum payout amount if you die early.

For example, a “life with 10-year certain” structure guarantees a lifetime payment regardless of how long you live. But if you died in year two, then there would be eight more years of payments to your listed beneficiaries. If you lived 11 years, then the income stream would obviously continue for your life (or lives, if joint), but no money would go to your beneficiaries.

Life With Installment Refund

This choice provides the highest lifetime income guarantee while making sure that 100% of the initial premium will go to you or your listed policy beneficiaries. If you die early in the contract, all of the unused money will be paid out to your beneficiaries in payment form until the funds in the account are exhausted.

Life With Cash Refund

This is similar to the “life with installment refund” structure, but instead of the unused portion being paid to your beneficiaries in payment form, it is distributed as a lump sum. The annuity carrier doesn’t keep a penny with either the installment refund or cash refund structures.

Life Only

This will provide the highest payout because you are shouldering all of the risk. The annuity company is on the hook to pay you for as long as you live, but when you die, the money is gone.

Most people mistakenly believe that this income structure is the way all annuity payouts work. This is untrue, but it is a common misbelief. If you don’t have a spouse, kids, pets or a charity of choice, then this would be your choice. However, most people don’t choose this payout option because they want their beneficiaries to get any unused portion of the initial premium.

Period Certain

Even though the true value of a longevity annuity is when you add the life contingency as a way to transfer the risk, you could choose to structure the payout for just a specific period of time.

For example, if you structured the policy “20-year certain,” then the income stream would be paid out for 20 years only to you or your listed beneficiary, even if you died during that time period. After the 20th year, there would be no more income payments.

Other Longevity Annuity Basics

It’s important to know that you can also structure these longevity annuity policies jointly with your spouse. Any “life” contingency that is joint with your spouse means that the lifetime income stream is guaranteed and uninterrupted for both lives, regardless of how long you live. The question that you have to answer is what type of guarantee, if any, you want to attach to the lifetime income guarantee.

Annuity lifetime income streams are primarily based on your life expectancy(ies) at the time you start taking payments. In essence, you are betting with the annuity company that you think that you will live longer than they think you are going to live. And if you do live longer, the insurance carrier is on the hook to pay you regardless of how long you live. That’s a simple definition and the pure value proposition of a longevity annuity.

Longevity annuities can be used in both IRA and non-IRA accounts. Recently, a new version of this product, called a qualified longevity annuity contract (QLAC), was approved by the government for use within 401(k) plans and personal IRAs. In my opinion, this QLAC decision is a game changer for the annuity industry and will signify the demand shift to simplistic and transparent products that consumers can easily understand.

What Is a QLAC?

On July 1, 2014, the U.S. Treasury Department and the IRS approved the use of qualified longevity annuity contracts within a 401(k) plan or traditional IRA. It’s important to know what a QLAC is, and how it could possibly benefit your specific situation.

Not all longevity annuities are considered QLACs, even though they are pretty much the same product. The major difference is that a QLAC is recognized by the IRS to allow deferral periods past the required minimum distribution (RMD) age of 70½. With a longevity annuity that doesn’t fall under the QLAC category, most carriers won’t even show you a quote deferring past 70½.

The main reason the QLAC ruling was passed is to help younger workers participating in their employer 401(k) to plan for future lifetime income needs when they eventually retire. A qualified longevity annuity contract is a future lifetime income stream that can be structured to pay you for as long as you live. There are no annual fees, no market growth attachments, and the strategy can be easily explained and understood. So the question is, how can this benefit the baby boomer or retiree?

The QLAC rules dictate that you can only use 25% of your total dollar amount in qualified accounts or $125,000, whichever is less. The other primary stipulation is that you can defer the income start date up to age 85.

Here’s where you need to pay attention, and where boomers and retirees can benefit from the QLAC ruling. For people with traditional IRAs, you will be allowed to lessen the taxes you pay on your required minimum distributions (RMDs) using the QLAC strategy while guaranteeing a lifetime income stream for you (and your spouse, if applicable) starting at a future date. If you are fortunate enough to not really need the income derived from present or future RMDs from your traditional IRA, you can take up to $125,000 out of that annual calculation. Let’s take a look at a specific case of how this QLAC required minimum distribution strategy works with your IRA.

For example, let’s assume you have $500,000 in a traditional IRA: You place $125,000 into a qualified longevity annuity contract and defer the income to start as late as age 85. You don’t have to defer it out that long, but that is the maximum age under the current rules. So when you go to calculate the required minimum distribution (RMD) from your IRA, you will be using $375,000 as the total instead of $500,000. Because it is a lower amount, you will be required to take less money out, which in turn means you would pay less in taxes.

If you die before the income stream is designated to start, then you can structure the QLAC contract so that 100% of the money will go to your listed beneficiary. (Refer to the first part of this article for how you can structure the income payouts.) You can also structure the QLAC policy for joint payment with your spouse, and be able to customize the income stream to reflect your specific planning goals.

As of the date of this article, there are actually no QLAC products available for purchase, and carriers are scrambling to put the needed paperwork and procedures in place to offer the strategy. My prediction is that QLACs will be available by the end of the calendar year, or the first part of 2015.

How Longevity Annuities Compare

There are 15 different types of annuities available, and each one has their own benefit propositions and contractual limitations. Longevity annuities solve for future income needs, or what I refer to as income later or target date income planning.

In the world of annuities, there are only two ways to solve for income later needs. One way is to use an income rider attached to a deferred annuity, like a variable or indexed annuity. An income rider is an attached benefit that typically grows at a contractual rate, with that guaranteed amount only used for income. Income rider valuations are monopoly money unless used for lifetime income. Income riders are flexible, but are taxed last in, first out (LIFO), meaning gains are taxed first when the strategy is in a non-IRA account.

Any money coming out of a qualified account, like a traditional IRA, is taxed at those IRA rules. That includes any type of annuity, including longevity annuities and QLACs.

When using a longevity annuity outside of an IRA (i.e., non-qualified account), the taxation of that income is favorable because it is annuitized. Annuitization is a combination of return of principal and interest, so you only pay taxes on the interest portion of the income. This is called the exclusion ratio in the annuity industry, and describes that part of that income is not taxable.

Longevity annuity quotes from your agent or adviser cannot be “juiced” from a proposal standpoint. Only the contractual guarantees can be shown, which is a good thing because you should own an annuity for what it will do and not what it might do. Always buy the contractual guarantees.

Longevity Risk

Longevity risk is simply the possibility of running out of money, or outliving your money. Annuities are the only product on the planet that contractually solve for longevity risk.

That fact certainly doesn’t mean that everyone needs to own a longevity annuity, or needs to own any annuity for that matter.

What it does mean is that it might make sense to consider whether this future income strategy makes sense for your specific situation.

Listen to Stan Haithcock’s presentation at the 2013 AAII Investor Conference!

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