IRS Proposes to Bless Longevity Insurance

On February 3, 2012, the U.S. Department of Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) issued proposed regulations that would exempt the purchase of a “Qualified Longevity Annuity Contract” (“QLAC”) from the account balance that would have to be distributed under the minimum distribution rules of Internal Revenue Code Section 401(a)(9).  This writer first heard about longevity insurance at a Joint Committee on Employee Benefits governmental conference where one speaker described this new product as a way to protect plan participants whose primary retirement vehicle is a defined contribution plan rather than a defined benefit plan.  The concept is that if a retiree takes a portion of his/her account balance at retirement (between age 55 and 65) and invests it in an annuity that doesn’t commence until age 80 or 85, the cost of the annuity would be low enough to be affordable for most retirees.  And if the retiree then lives to that age (as so many retirees now do), the annuity would kick in to provide income by the time the original account has been depleted.  Of all of the ideas promoted at that session, longevity insurance appeared to be the most attractive and least disruptive to plan administration.

The idea continued to percolate in the retirement community and, particularly, among the regulators at IRS.  The biggest impediment to implementation was Section 401(a)(9).  While Section 401(a)(9) is quite complex, by way of a concise description, this section requires distributions to commence on April 1 after attainment of age 70½ (the required beginning date), and to continue at a minimum level for the life expectancy of the retiree (and spouse or beneficiary, if any), and no more than 50% of the balance can be deferred past the retiree’s expected lifetime (except for a spouse). Essentially, if a retiree and spouse have a 25-year life expectancy in a given year, 1/25 of the account must be distributed that year, and 1/24 of the account the next year.  Life expectancies can be fixed at the commencement of the required minimum distribution period, or can be recalculated each year. If life expectancies are not recalculated, the account will be depleted at the end of the original life expectancy (the distribution ratio becomes 1/1 in the last year).  But if life expectancies are “average,” half of all retirees can be expected to outlive the original life expectancy.  Recalculation allows the account to be stretched out past the initial life expectancy, but then at death, the entire account must be distributed because the life expectancy is now zero, while with no recalculation, the distribution can continue at the original rate. 

The concern that these rules created for longevity insurance is that because distributions do not commence until well after the required beginning date, the annuity contract has to be linked to the original account for purposes of determining the required minimum distribution each year.  If the original account is depleted (by distributions in excess of the minimum) before the annuity commences, the retiree has to take an early distribution from the insurance contract (or cash it in) in order to satisfy the minimum distribution requirement applicable to the original account.  This potential for early distribution has to be factored into the pricing of the contract, even if it is extremely unlikely that an early distribution will be required.

The proposed regulations exempt a QLAC from the minimum distribution rules as currently constituted, and essentially create a new category of minimum distribution rules applicable only to QLACs.  The QLAC, if the proposed regulations are adopted, would allow a participant or IRA account holder to apply up to 25% (but not more than $100,000) of the account (at or before the required minimum distribution date) to the purchase of an annuity contract that defers commencement to age 85 (or earlier).  The contract can allow the purchaser to commence before age 85 (or not), but age 85 was selected as the latest possible commencement date because that is the current life expectancy of an age-65 retiree.  Just as the $100,000 maximum purchase limit would be indexed for inflation, the preamble indicates that the age 85 limit might be revised if life expectancies continue to increase.  Note that the $100,000 maximum purchase limit applies to all accounts covering the individual – an employer plan must keep track of this limit for all accounts maintained by the employer or an affiliate, but an IRA provider can accept the purchaser’s representation as to prior purchases of QLACs.  An IRA purchaser can combine IRAs to satisfy the 25% limit (so that one IRA can be used to purchase the QLAC if the owner has other IRAs worth three times as much in the aggregate).

There are complicated rules included for survivor annuities associated with QLACs – generally, it is simpler to have a spouse beneficiary than a non-spouse beneficiary, and distributions to a spouse beneficiary can be delayed to the original expected commencement date (thereby reducing the cost of the survivor annuity).  Because of the 25% account limit, it is unlikely that the QLAC would be subject to an employer plan’s requirement to offer a qualified joint and survivor annuity because the qualified joint and survivor annuity requirement applies to only half of a defined contribution plan’s account balance (most defined contribution plans are exempt from this requirement).  No other post-death options are available (such as return of premium or period certain).

As a practical matter, of course, employer plans rarely distribute defined contribution accounts over a life expectancy – more and more have moved to a “lump sum only” mode because it minimizes administrative costs.  The required minimum distribution rules are of interest mostly for those who administer IRAs (and those who own them), and for smaller plans in owner-operated businesses.  We predict that the availability of QLACs will not change the employer plan preference for lump sums only.  Unless the plan’s third party administrator is already offering annuities upon distribution (common only in plans administered by insurance companies), it is unlikely that the QLAC would become a common feature.  But it could become attractive for rollovers of large IRA balances, if there are enough insurers willing to offer these policies at competitive rates.  What has kept the employer plans away from annuities has been a perception that the fees and expense loads associated with annuity contracts do not meet the standards expected from other plan investment providers, particularly in an environment where fees must be disclosed and plaintiff lawyers are filing lawsuits over allegedly-excessive fees in defined contribution plans.

The preamble to the proposed regulation indicates that if the insurer is offering annuities at a 3% rate of return, an annuity purchased for $100,000 at age 70 could offer an annual benefit of up to $42,000 per year (without taking into account any expense load).  If the insurance community in fact offers QLACs in this range, the product could become an attractive option, particularly for retirees with a family history of longevity.  The challenge is that most employers have been focused on educating employees to make better investment decisions, but have not been focused on educating retirees (or those soon to retire) on preparing for life after retirement.  Many retirees have a distorted perception of their life expectancy and may not recognize that they are reasonably likely to live past age 85.  Even if an employer plan does not offer QLACs, the availability of such products may serve as a reminder to include retirement planning in employee benefit educational programming.

Information contained in this publication is intended for informational purposes only and does not constitute legal advice or opinion, nor is it a substitute for the professional judgment of an attorney.