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QLACs Offer New Retirement Planning Options, Advisors Must do their Due Diligence

Posted by Duane Thompson on July 23, 2014

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Recent regulations issued by the Department of Treasury, four years in the making, offer an intriguing new retirement planning option for pension and retail advisers by easing required minimum distribution rules to encourage the purchase of deferred-income annuities.  The new rules went into effect July 2.

The new regulations generally allow participants in defined contribution plans, as well as IRA account holders, to purchase what Treasury calls a Qualifying Longevity Annuity Contract, or QLAC, exempt from mandatory distribution rules at age 70½.  The latest guidance is part of the Administration’s broader effort to “bolster retirement security and saving,” according to Treasury’s press release.

There are certain restrictions, of course, and investment fiduciaries will have unique considerations when performing their due diligence.  QLAC premiums are limited to 25 percent of an individual’s total retirement account balances, or $125,000, whichever is less.  Perhaps the most attractive feature responds to buyers’ traditional reluctance to purchase annuities, a resistance sometimes called “getting-hit-by-the bus syndrome” in industry circles.  The return of premium feature in QLACs, which is not an optional rider, allows the return of payments already made (excluding benefits received) if the annuitant dies before or after distributions begin.

While commenters to the proposed rules noted this benefit would make QLACs more expensive, Treasury responded that “the effect would be relatively small and employees would still be more likely to choose an annuity with this feature than without it.”  Thus, part of the suitability obligation of an advisor to a retail client would be comparing the cost of a deeply deferred annuity to a traditional fixed annuity or alternative investments used under RMD rules.  One observer estimated the return of premium benefit would add 5 to 10 percent to the QLAC premium.

Part of Treasury’s rationale in limiting a QLAC to a portion of a worker’s retirements assets was liquidity concerns.  Treasury stated that the $125,000/25 percent limits were needed “in order to constrain undue deferral of distribution[s].”  Treasury’s release suggested the current restrictions are sufficient.  It provided the example of a person age 70, who purchases a $100,000 premium with payments commencing at age 85, could receive an annual income ranging from $26,000 to $42,000.  An investment advisor’s determination of suitability is made somewhat easier by Treasury’s elimination of other riders that often make it difficult to make apples-to-apples comparisons between annuity contracts. 

The new guidance, for example, prohibits the use of a cash surrender value or similar feature in a QLAC.  The agency noted such features “would significantly reduce the benefit of mortality pooling.” In addition, variable or equity-indexed annuities would not qualify as QLACs, notwithstanding concerns over inflation risk.  Treasury rejected the use of variable annuities by noting that the purpose of a QLAC is to provide a predictable stream of lifetime income.  Equity returns, according to Treasury, are available through an individual’s control of his or her remaining account balance.

In order to qualify as a QLAC, the annuity contract must state in the policy, or in an insurance certificate or other rider for existing policies that meet the requirements previously mentioned, that the contract is intended to be a QLAC.  The new rules apply to most defined contribution (DC) plans, including 401(k), 403(b), and Section 457 plans, as well as traditional IRAs.

QLACs are not available to defined benefit (DB) plans, Treasury noting that such plans are already required to offer longevity protection through annuities.  Nor do the new rules apply to Roth IRAs inasmuch as they are not subject to RMD rules.  Thus, an annuity purchased in a Roth IRA would not be deemed a QLAC, even if the annuity contract otherwise met the new requirements.

The final regulations prescribe minimum and maximum starting dates for QLAC annuity distributions.  Payments can begin no earlier than age 70½, or the calendar year in which the employee retires.  The latest initial distribution date must begin no later than the first day of the month following the annuitant’s 85th birthday.

Of course, one of the most important considerations for investment fiduciaries is the financial strength of the insurer, due to concerns that the annuity provider would be financially able to make all future payments.  QLACs heighten those concerns, given that some annuitants may elect to receive distributions after age 85.  Until Treasury, the Internal Revenue Service, or the Department of Labor provide additional guidance, it seems likely that pension advisors will continue to look to the DOL’s existing guidance for prudent selection of an annuity provider to a qualified plan.  An excellent overview of an ERISA fiduciary’s due diligence requirements can be found in a white paper published in 2012 by the law firm Drinker Biddle.

Investment fiduciaries also should carefully consider whether it is preferable to purchase a QLAC through an eligible defined contribution plan or IRA, if both options are available.  A spokeswoman for the Pension Rights Center, while applauding the new rules, stated that IRA mortality tables are gender-neutral, which would treat women unfairly since they generally live longer than men.

Most industry observers seem uncertain whether the retirement market will embrace QLACs, notwithstanding the RMD carve-out and return-of-premium guarantee.  A Morningstar analysis earlier this year indicated longevity insurance sales are increasing substantially, even though overall annuity sales are flat.  Others have suggested that QLAC sales are unlikely to increase significantly until the Department of Labor acts on its proposal to require plan sponsors to disclose lifetime income illustrations of their workers’ individual account balances.

Still, despite the traditional reluctance of many investment advisors to recommend annuities, it is possible they will give QLACs a fresh look.  The challenge of addressing longevity risk through a new guaranteed income strategy via QLACs may indeed appeal to some.  However, like any new product on the market, this one will require its own unique approach to kicking the tires before making a purchase.

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