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.
Background
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.
Longevity protection
In this section, I'll use an example to compare three strategies for providing longevity protection:
DIAs for longevity protection and TIPS ladders during the deferral period
SPIAs with and without a cash refund at death
-
TIPS ladders to support withdrawals to age 90 or 100
The example is based on a 65-year-old female. TIPS yields are as of early March 2015 with the 10-year and 15-year TIPS at .25% and .50% respectively. I subtract .15% for laddering expenses. The DIA and SPIA payout rates are from Income Solutions®. All figures are per $100,000 invested.
Inflation-adjusted lifetime income options for a 65-year-old female
Product |
TIPS/DIA Allocation |
Monthly income per $100,000 premium |
Annualized payout rate |
No-refund SPIA |
NA |
$385.71 |
4.63% |
TIPS and DIA 65/75 combination |
42%/58% |
$354.81 |
4.26% |
TIPS and DIA 65/85 combination |
83%/17% |
$348.37 |
4.18% |
Cash refund SPIA |
NA |
$340.94 |
4.09% |
All TIPS--payments to age 90 |
100%/0% |
$348.18 |
4.18% |
All TIPS--payments to age 100 |
100%/0% |
$253.01 |
3.04% |
Source: Income Solutions® and author's calculations |
The no-refund SPIA provides the highest income with inflation-adjusted payments similar to Social Security. The disadvantages are that heirs receive nothing in the event of an early death, and there is no liquidity.
I show two strategies using DIAs. For each, I calculate the TIPS/DIA mix that will produce a smooth transition from TIPS withdrawals to DIA income with a goal of generating inflation-adjusted lifetime income beginning at 65. The shorter deferral period (to age 75) requires more of the initial $100,000 invested in the DIA. The DIA strategies produce less income than the no-refund SPIA but have the advantage of providing both liquidity and funds for heirs during the deferral period. The greatest liquidity is provided by using the DIA 65/85, but the tradeoff is a 10% reduction in income compared to the no-refund SPIA. A disadvantage of using DIAs is that the inflation adjustments do not begin until the DIA income starts, so it is necessary to guess at the inflation rate over the deferral period. For this example, I assumed 1.9% inflation based on the yield spread between Treasuries and TIPS.
I also show results for a cash-refund SPIA. This refund provision provides a guarantee that the purchaser or heirs will recover the initial premium as monthly annuity payments or as an additional payment to heirs if cumulative payments at death fall short of the initial premium. The amounts going to heirs at death are greater for this product than for the DIA strategies. At year 10, this product would pay $59,000 to heirs, compared to $42,000 for the DIA 65/85 and zero for the DIA 65/75. However, the no-refund SPIA doesn't provide any living liquidity.
Finally I show results using only TIPS to provide lifetime income. The life expectancy for a healthy, upper-class 65-year-old female is about 25 years, and I show both a TIPS strategy to life expectancy (age 90) and to age 100. The TIPS to life expectancy strategy generates income similar to the DIA strategies, but there is a 50% change of depleting funds while living. The SPIA and DIA strategies provide 100% assurance of receiving income for life. This difference in outcomes highlights the value of longevity pooling that these annuity products offer. Without the benefit of longevity protection, it is necessary to assume a longer-than-expected lifetime, and I've chosen age 100. This might seem shockingly conservative to those who don't study mortality tables, but the range of estimates I have looked at recently put the odds for the 65-year-old female in this example living to 100 in the range of 5% to 11%.
Pre-retirement
Workers saving in defined-contribution (DC) plans face growing sequence-of-returns risk during the years leading up to retirement. Savings balances are increasing, so more money is at risk with fewer years left to recover if investment performance turns sour. The chart below, based on a 55-year-old aiming to retire in 10 years, illustrates the dilemma that participants face.
10-year accumulations in real dollars, percentile outcomes
Stock/Bond |
10th
|
25th |
Median |
75th |
0/100 TIPS ladder |
$101,005 |
$101,005 |
$101,005 |
$101,005 |
0/100 TIPS fund |
$81,002 |
$89,848 |
$101,232 |
$113,701 |
25/75 (stock/bond) |
$88,897 |
$100,585 |
$115,193 |
$132,618 |
50/50 (stock/bond) |
$87,050 |
$106,197 |
$131,936 |
$164,450 |
75/25 (stock/bond) |
$81,410 |
$108,236 |
$149,502 |
$206,075 |
100/0 (stock/bond) |
$74,755 |
$110,827 |
$170,386 |
$260,256 |
Source: Author's calculations
Assumptions: Stocks 5.35% real return, 20% SD; TIPS .10% real return, 5.5% SD |
Savers face a choice of going to fixed income investments and not earning much or adding equities to the mix and increasing the volatility of outcomes. An alternative strategy for this particular example would involve purchasing a DIA 55/65.
The chart below compares DIA strategies at age 55 and alternatives:
Inflation-adjusted lifetime income at 65
Product |
Monthly income per $100,000 premium |
Annualized payout rate |
No-refund DIA 55/65 |
$548.73 |
6.58% |
Cash-refund DIA 55/65 |
$518.08 |
6.22% |
TIPS at 55 converting to a SPIA at 65 |
$469.35 |
5.63% |
50/50 Stock/Bond at 55 (median) |
$613.08 |
7.36% |
50/50 Stock/Bond at 55 (10th %) |
$404.50 |
4.85% |
Source: Income Solutions® and author's calculations |
The top two rows are the DIA strategies. Not surprisingly, the cash-refund DIA pays less than the no-refund version, but neither strategy provides any liquidity while the purchaser is alive. The third line is a strategy that seeks safety by moving money to TIPS at age 55 and then converting to a SPIA at age 65. This strategy would provide liquidity until the SPIA is purchased; however, the SPIA rate at 65 would not be known with certainty until age 65.
The income advantage for the DIA strategies over the TIPS/SPIA strategy is substantial, and this reflects the longer duration of investments to support DIAs. The duration of income payments from a DIA 55/65 with the start of payments delayed 10 years is about 20 years, compared to about 10 years for a SPIA issued at age 65 with payments beginning immediately. Insurers can earn extra yield by investing further out on the yield curve and earn higher credit spreads as well. A portion of this extra yield results in higher payouts.
The last two rows show the impact of taking investment risk during the pre-retirement years. The median income exceeds the income for the DIA strategies, but the 10th percentile is significantly below, illustrating the risk of relying on equities.
Other products for pre-retirement
The focus of this article has been DIAs, but one can also use variable and fixed-index annuities during the lead-up to retirement. These products may provide premium bonuses, effective at purchase, and roll-ups that guarantee growth in a notional benefit base that can be used to generate guaranteed lifetime withdrawals. Roll-ups of 5% compounded and 7% simple are common. They can produce attractive levels of guaranteed withdrawals although inflation-adjusted withdrawals are not offered.
The products are complicated, however, and advisors recommending them need to understand product details (contained in prospectuses hundreds of pages long). In particular, advisors need to be aware of insurer flexibility to adjust charges and credits after sale. It is also necessary to be up-to-speed on the full array of products available in order to choose those that best meet particular client needs. These products often carry high fees; in the case of fixed-index annuities, those fees may not be easily discernable by the advisor
Final word
What emerges from this comparison of DIAs versus other alternatives is that no particular product choice clearly dominates. Achieving higher income generally requires giving up liquidity and flexibility. There will be articles from time to time arguing that the DIA (or some other product) beats all the others, but such claims should be viewed with skepticism.
Joe Tomlinson, an actuary and financial planner, is managing director of Tomlinson Financial Planning, LLC in Greenville, Maine. His practice focuses on retirement planning. He also does research and writing on financial planning and investment topics.
Read more articles by Joe Tomlinson
