Earlier this month, with absolutely no fanfare, the Treasury Department announced what could be a major change in the way we save for retirement. It will now permit people to shift a portion of their 401(k)s or IRAs into a deferred annuity that provides a guaranteed stream of income once you reach old age.
The idea has the potential to fix several flaws in today’s defined contribution retirement plans and it could make it easier for many older Americans to pay for long-term care. But it raises two huge questions: Will consumers understand these complex products, and will insurance companies bother to sell them to a mass market?
Under the new Treasury rules, you’ll be able to use up to one-quarter of your retirement account balance, to a maximum of $125,000, to buy a deferred income annuity. Funds used to purchase the annuity will be exempt from the normal rules that require minimum distributions from 401(k)s starting at age 70 ½. Those rules have effectively prevented people from using these dollars to buy deferred annuities.
Sometimes called longevity annuities or longevity insurance, these are single premium investment products. You pay a lump sum up front at, say, age 65. At some later point in your life, say, age 75 or 80, you begin receiving a regular, guaranteed income payment until you die.
Delaying the income significantly reduces the initial premium. Or, to put it another way, your monthly income on the same premium is much higher if you wait a decade or more to begin collecting.
According to New York Life, if you buy a $50,000 immediate fixed annuity at age 65, you can expect to receive about $275-a-month. If you buy at 65 but defer income until age 80, you’ll get more than $1,200 every month.
Since people are more likely to begin incurring long-term care costs after age 80, setting up a deferred annuity that begins paying out at that age may be an alternative or a supplement to a standard long-term care insurance policy. Some carriers have been selling such “combination products” and they report growing consumer interest, though overall take-up is still very low.
Of course, there are risks to waiting. One is that you’ll die before you make back your initial investment, much less earn a return. The second is that inflation will eat away at the value of that future income.
Many consumers have resisted buying deferred annuities, in large part because they pay only during the purchaser’s lifetime. Once he dies, payments cease.
To make the product more attractive, the Treasury rules permit two features that have become popular with investors: A “return of premium” where the insurance company will refund money that has not yet been paid out, and a rider that allows the buyer to designate a beneficiary who continues to receive payments after the buyer’s death.
Of course, increasing flexibility costs money, and will shrink your monthly payment.
Still, longevity annuities may make sense for many consumers. But will potential buyers get comfortable with them, and, even if they do, will insurance companies really try to build a mass market of modest accounts.
At the end of 2013, the average 401(k) balance for workers 55-64 was about $165,000, according to a study by Fidelity. Because the new rules only allow people to spend 25 percent or less of their account balances on the annuities, many investments will be $40,000 or smaller. I suspect many will be well below $10,000. And, historically, financial firms have been disinterested in managing large numbers of very small accounts like these.
Still, the new Treasury rules create an important alternative for people looking to save for very old age. These annuities make it less likely people will outlive their assets and may make more money available for long-term care just when many are likely to need it.
Howard, the real risk is that you buy now and lock in a rate based on today’s historic low interest rates. Five years from now, if interest rates and inflation rises you’ll have what looks like a miserable deal..
You are correct that this may not be the optimal time to buy an annuity. But keep in mind that the deferred annuity feature is an option only. And while interest rates are low today, they won’t stay low forever (I promise). Also, for many, this tool is not a pure substitute for LTC insurance. Many annuitants could not afford insurance or would fail underwriting. This may be their best option.