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The Wall Street Journal of July 23, 2023 included an article on QLACs — Qualified Longevity Annuity Contracts — with this, to me, eye-popping title, “A Retirement Tax Break That Ends the Fear of Outliving Your 401(k).” The article, by Ashlea Ebling, starts with this paragraph:
Millions of Americans have good reason to worry they will outlive their retirement savings. A little known tax-advantaged annuity can help avoid that, providing a guaranteed income in the final years of life.
An annuity, in its simplest form, entails surrendering a sum of money to receive a fixed income stream that continues until you die. The QLAC is a special type of annuity. It’s deferred. You hand over money now for a survival-contingent income stream that begins in the future.
Ebling provides an example of a 65 year old buying a QLAC for $200,000 today that would pay $134,100 a year starting the year the person reaches age 85. That certainly sounds like a fabulous deal.
Even better, there’s a supposed tax break. The $200K the person spends on the QLAC is exempt from required minimum distributions (RMDs). Given the persons age, RMDs kick in starting at age 73. (Last year’s Secure 2.0 Act raised the RMD starting age for a current 65 year old to 73 from 72. For those born in 1960 or later, the RMD starting age is 75.) Yes, the person will have to pay taxes on their QLAC stream, but that’s not till age 85 — 12 years after they reach age 73. And if they die before 85, they’ll have escaped taxation on the $200K entirely!
If all this sounds too good to be true, it’s because it is.
To begin, the person, if male, has only a 55 percent chance of making it to 85. Then there’s a crucial word — inflation, which appears not once in the Journal article. Let’s suppose inflation over the next 20 years cumulates as it did over the past 20 years. Then the $134,100 payment will lose 38.6 percent of its purchasing power over the next 20 years. That’s all before the QLAC annuitant receives a penny of income on the policy. In other words, the first’s years payment, starting at age 85, will be worth only $82,337 in today’s dollars. Multiply this by .55, the chance of this assumed male living to 85, and we’re talking an expected real payment of only $45,286 in the first payout year.
But the real yield on 20-year inflation-indexed bonds is currently 1.58 percent. And the discount (make less of) factor for real dollars 20 years from now is currently .73. Multiply $45,286 by .73 and we’re talking $33,058 as the QLAC’s present value expected first-year payment.
That’s only 16 percent, not 67 percent ($134,100 divided by $200,000) of the original $200K invested. Moreover, today’s 85 year-old male has only 6 years, on average, left to live. Given this, given the likelihood of inflation, potentially super high inflation, after age 85, and given real discounting, the QLAC total present expected value of nominal payouts from age 85 to death no longer looms so large. Indeed, it may be far south of $200K.
The difference between the present expected value on the QLAC and the $200K immediate outlay is the cost of the QLAC’s load — its load. To be fair, this load may be no higher than on, say, immediate annuities or on fixed-term life insurance policies. But establishing that fact requires a detailed actuarial analysis that incorporates not just survival probabilities, but also probabilities of future inflation rates.
Of course, no insurance policy is a slam dunk. They all have loads. And our concern with risk makes us willing to buy insurance even when loads are high. But, at some point, when the load is too high, buying the policy makes no sense relative to taking the risk and self insuring to the extent possible. The self insurance options here include saving more, downsizing and moving to a state with lower taxes, working longer, optimizing lifetime Social Security benefits, and doing tax-efficient Roth conversions.
Today’s 65 year-old can also make real as opposed to nominal insurance arrangements with his children, siblings, or close friends. This paper entitled, The Family as an Incomplete Annuities Market, which I wrote jointly with Israeli economist, Avi Spivak, is now almost a half century old. But most economists who study annuities, whether immediate or deferred — particularly the question of why so few people buy them — know the paper and its message. Family insurance can avoid loads, adverse selection (insurance customers knowing things, including their chances of making it to 85 and beyond, far better than insurance companies), and, most important, inflation by making implicit real, not nominal family insurance contracts.
But let’s assume the 65 year-old in question is single or isn’t talking to his 4 siblings and 5 children, let alone able to form an implicit, let alone an explicit real annuity arrangement with them. So, longevity is a huge risk to this 65 year-old. Hence, that potentially very expensive QLAC might well be worth it were inflation to evolve as expected. Unfortunately, like the person’s lifespan, future inflation is anyone’s guess. The markets certainly had no clue it was coming back in 2020.
Hence, buying a QLAC lowers the person’s exposure to one major risk — lifespan risk, but raises exposure to another — inflation risk. Yet the title of the Journal article (Note: Editors, not writers, almost always choose titles of newspaper articles.) doesn’t pull any punches. The QLAC, the title says, ends the fear of outliving one’s 401(k). That’s certainly not the case if we’re talking real spending, as opposed to nominal spending power. And real spending is the only thing that matters.
What about the assertion that the QLAC is a “tax break.” Again, not so fast. Yes, the putative QLAC purchaser would pay no taxes whatsoever on the $200K between ages 73 and 85. On the other hand, if the person lives to enjoy QLAC’s payouts, whatever their real values, his tax bracket may be far higher than would have been the case had they not purchased the QLAC. The reason is that the person will be clumping more taxable withdrawals into fewer years, potentially pushing them into higher tax brackets.
Moreover, our federal income tax and 42 (including Washington, D.C.) state income taxes tax nominal, not real asset income. A good chunk of the future taxes levied on the $134,100 will represent taxation of the inflation component of the $134,100 — the fact that its value is far higher given expectations of inflation embedded in today’s long-term nominal interest rates.
But, put aside inflation to focus on the tax-bracket concern. Certainly, deferring one’s taxes permits greater inside build up. But pushing oneself into a higher tax bracket can more than offset that advantage. Indeed, as illustrated here, retirees may do better, in terms of reducing lifetime taxes, by starting their tax-deferred withdrawals as soon as they retire, which, for most early retirees, is in their early 60s. There is, unfortunately, no one rule that fits all. Much depends on when one starts their Social Security benefits, whose taxation can be triggered prematurely by early withdrawals.
Medicare’s Part B’s progressive IRMAA premium also enters into the QLAC decision. The premium’s top bracket isn’t indexed for inflation. Consequently, large nominal QLAC payments starting at 85 could place our hypothetical deferred annuitant into the highest IRMAA bracket.
In sum, there are many critical considerations in evaluating QLACs. Our country is beyond broke on a long-term basis and has been using inflation to water down its outstanding debt. That seems more likely than not to continue. Hence, the risk of high and variable future inflation is very real and very important to anyone contemplating swapping the real dollars they hold today for nominal dollars — literally pieces of paper called dollar bills — that would, if at all, be paid decades from now and whose purchasing power could be next to nothing. Thus, rather than “ending” the fear of outliving your 401(k), QLACs can greatly exacerbate it.