How Do Deferred-Income Annuities Stack Up Against Rival Products?
March 24, 2015
by Joe Tomlinson
Deferred-income annuities (DIAs) have received a lot of attention with new Treasury Department regulations encouraging their use. Many tout them as providing the most cost-effective way to generate retirement income. But retirement products are not one-size-fits-all. I’ll show where DIAs fit among the products and investment solutions available to advisors.
The DIA is a simple, easy-to-understand annuity product. In exchange for an upfront premium payment, the purchaser receives a monthly income for life that begins after a deferral period. For example, a 65- year-old individual might purchase a DIA with payments that begin at 85 in order to protect against outliving savings. Another example would be a working 55-year-old individual purchasing a DIA with payments beginning at 65 in order to provide secure retirement income and to reduce the impact of investment volatility in the years leading up to retirement.
There are a few different versions of the product. One can elect level payments, payments that increase by a fixed percentage each year or payments that adjust for actual inflation. For the latter version, the inflation adjustments do not begin until payments start, so the purchaser bears the inflation risk during the deferral period. The products are offered both for single-lives and for couples. Purchasers also have the option of electing a refund feature paid to heirs in the event of death during the deferral period.
Although the product is simple, it is referred to by a number of different names, which can cause confusion. In addition to DIA, names include: advanced-life deferred annuity (ALDA), longevity insurance, deeply deferred annuity and, most recently, qualified longevity annuity contract (QLAC) – a Treasury Department designation for a subset of DIAs. The nomenclature I’ll use in the remainder of this article is DIA X/Y, with X representing the purchase age and Y the age when payments begin, for example, DIA 65/85.
DIAs have been available since the 1950s, but only started receiving attention when a few insurers began promoting them for longevity protection about ten years ago. Sales of the product have not yet gained momentum. The LIMRA Secure Retirement Institute estimated 2014 DIA sales at $2.7 billion. That was up from $2.2 billion in 2013, but still only a tiny fraction of the $236 billion annuity market.
In 2014, the Treasury Department took two separate actions to encourage the use of DIAs. In July, Treasury issued regulations exempting DIAs from required minimum distribution (RMD) rules. This had been a problem for tax-deferred accounts and versions like the DIA 65/85; the RMD obligation begins at 70½ but payments don’t begin until 85. Treasury now allows the lesser of 25% of total tax-deferred retirement accounts or $125,000 to be used for DIA purchase without RMD rules applying. The intention is to promote the use of DIAs for longevity protection.
In October, Treasury issued guidance allowing 401(k) plan sponsors to offer target-date funds that include DIAs among their assets. Instead of stocks and bonds only, target date funds can now include stocks, bonds and DIAs. The objective was to focus on the years leading up to retirement and provide a way for participants to shift portions of their 401(k) out of stock and bond funds and into lifetime income.
It’s too early to tell if these Treasury actions will significantly boost the popularity of DIAs. To some extent, the future of DIAs will depend on how effectively these products meet retirement income needs compared to other annuity products or investment approaches.
In the remainder of this article I will analyze a longevity version (DIA 65/85) and a pre-retirement version (DIA 55/65). I have previously written about DIAs in Advisor Perspectives here, here, and here, but these articles are a few years old, and it’s time to provide new insight. My particular focus for this article will be on a “safety-first” approach to retirement planning. I’ll compare products or investment approaches that provide guaranteed income and inflation protection needed to build a floor of retirement income in addition to Social Security.
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