If you have never heard of a deferred income annuity, get ready, because you’ll probably be hearing a lot about them in the near future. And honestly, you should want to!
Deferred income annuities address a major weakness that is a part of current tax-deferred retirement plans, such as 401(k)s: what to do with your retirement plan when you actually retire.
That’s where deferred income annuities come in. They’re a valuable tool you can use that can preserve your investment capital, and make sure that you have a steady income for the rest of your life – no matter how long you live.
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They can even turn your defined contribution 401(k) into something resembling the traditional defined benefit plans of yesteryear. That should interest anyone and everyone who is planning for retirement.
What is a Deferred Income Annuity?
Deferred income annuities are a cross between deferred variable annuities – which come with guaranteed benefits – and immediate annuities.
With a variable annuity, you allow the plan to grow for a number of years, and only begin withdrawing funds at a certain, predetermined date. With an immediate annuity, your monthly payments will be fixed for the rest of your life. Also under an immediate annuity, the monthly payment will not increase the way it can with variable annuities. But just like the name says, you can get payments almost immediately.
Deferred income annuities came about in 2011, and represent something of a hybrid between these other types of annuities. They came about in part because of the 2007-2009 stock market slide. Insurance companies had been promising lifetime guaranteed benefits equal to between 5% and 6% of the annuity's base value on variable deferred annuities, but struggled to pay at those rates given the strong market decline.
The Rarely Discussed Problem of Investing After Retirement
Why is this discussion of deferred income annuities important?
Perhaps the most basic problem with investing for retirement is that there is almost no consideration or discussion of what will happen after retirement. Virtually all the discussion is about how to accumulate a large enough retirement portfolio to guarantee that you will be able to live comfortably, and at the standard to which you have become accustomed.
The topics of how you will invest your money after retirement, and how it will be distributed in a way that will prevent you from outliving your money, almost never comes up.
But those are actually equally important considerations in planning for your golden years.
No matter how well you have invested your money up until the point that you retire, you can still have a less than satisfactory retirement if you don’t handle your money well once you're no longer working.
There are two basic post-retirement considerations that need examination as a basic part of the retirement planning process:
- How to invest your money after retirement, and
- How to distribute your retirement assets in a way that will prevent you from outliving your money.
Until recently, both questions were more of a gray area. But within the last few weeks we’ve gotten some clear direction.
New US Treasury Department Guidance to the Rescue
In 2007, the US Department of Labor issued regulations that required certain types of diversified investment products referred to as Qualified Default Investment Alternatives, or QDIAs. The purpose of these alternatives was to create an investment framework for employees who have been automatically enrolled in an employer-sponsored 401(k) plan.
Where once employees had to actively elect to be in an employer plan, the new default was set that an employee would automatically be enrolled unless he or she specifically opted not to. But when automatic enrollment took place, the money accumulated in the plan would automatically be invested in money market funds that pay next to nothing in investment returns.
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In the 2007 ruling, the money is now automatically invested through QDIAs. QDIAs can include any one of the following investment types:
- Target date funds
- Lifecycle funds
- Balanced funds
- Managed accounts
But new regulations issued in October by both the US Treasury Department and the US Department of Labor have cleared the way for 401(k) plans to include annuities as one of the choices that can be included as a QDIA. This is a significant development, since annuities are specifically set up with the intention of providing for a monthly distribution of income over the beneficiary’s lifetime.
The Treasury Department's guidance notes the following:
“A deferred income annuity provides an income stream that generally continues throughout an individual’s life but is not intended to begin until some time after it is purchased. This can provide a cost-effective solution for retirees willing to use part of their savings to protect against outliving the rest of their assets, and can also help them avoid overcompensating by unnecessarily limiting their spending in retirement.”
In this way, the federal government is finally taking aim at the generally overlooked issue of specifically how retirement plans will provide income for retirees. In fact, the Department of Labor is expected to issue additional regulations requiring retirement plan sponsors to provide disclosure as to how much income a 401(k) plan will provide to the plan participant – rather than the current method of reporting only investment performance and current balance.
It’s all a huge step in the right direction.
Deferred Income Annuities to the Rescue
A deferred income annuity can create an income distribution program that is very similar to defined benefit pension plans. These plans have become extremely rare, but are the very foundation of income for many of those who are very comfortably retired today. The absence of defined benefit plans is one of the biggest sources of retirement insecurity among those who don't have one.
Money invested in a 401(k) plan can now be moved into a deferred income annuity. This will provide the beneficiary with a predictable income for the rest of his or her life. You can either begin taking income payments at the time of retirement, or you can allow the money to stay in the annuity and continue to grow. The longer that you wait to begin taking distributions, the larger the annuity will be, and the larger your monthly income payments will be as well.
This is an important option to have. At age 65, statistically the average male will live to be 84, while the average female will reach 86. This provides roughly 20 years that will need to be covered by income payments for retirement. But many people are in excellent health upon reaching retirement age, and have no immediate need to begin taking retirement income. By deferring the receipt of income, they can substantially increase the amount they will get at a later date.
For example, it may be possible for a person to retire and begin taking Social Security at 65, but continue to work part-time until age 70 or 75. If that person can defer taking retirement income during that 5 to 10 year window, the monthly income from the annuity will be substantially larger.
How Deferred Income Annuities Can Help Your Retirement Planning
It’s important to understand that if you invest money in a deferred income annuity, you won’t be able to withdraw the money in a lump sum at a later date. However, that restriction generally results in a much higher annual payout than what you can get from most variable annuities.
The RMD Work-around
Technically speaking, you are required by law to begin taking withdrawals from any tax-sheltered retirement plan (except for a Roth IRA) beginning no later than 70 ½. This regulation is referred to as Required Minimum Distributions, or RMDs.
Deferred income annuities can be structured to meet this requirement. However, they also offer a potential workaround. If you want to defer income beyond 70 ½, you can invest in a deferred income annuity using non-tax-sheltered assets. This can also be a way of earning higher income, since interest rates are currently at historic lows. Should interest rates return to their historic norms, you will be able to take out a new annuity at the then higher rates, and increase your income distributions as a result.
Deferred income annuities go a long way toward solving the income distribution side of the retirement equation. You’ll now have options as to how you want to handle the income that you’ll receive retirement, as well as the ability to make sure that you will have it for the rest of your life.
If you are at all concerned about what will happen with your 401(k) plan once you retire, contact me and we can discuss your options. You may find that a deferred income annuity is exactly what you need to make sure you will have a steady income, and that you’ll never outlive your money.