Good annuities have both low commissions and mortality credits. While Single Premium Immediate Annuities (SPIAs) clearly are good annuities for white coat investors (when they replace bonds in a distribution portfolio), there are additional annuities that I want to tell you about.
Qualified Longevity Insurance Contracts (QLACs) are good annuities for white coat investors. Not only do they have low commissions and mortality credits, but they also let you diversify your retirement investments and provide longevity insurance. QLACs are fixed, deferred annuities that pay you a future income stream in exchange for a single premium payment. They are Deferred Income Annuities (DIAs) for your pre-tax retirement accounts.
First, an explanation of what all these annuities are.
DIA: A deferred indexed annuity. It's essentially longevity insurance in your after-tax accounts. These are not right for most white coat investors though they have low cost and utilize mortality credits.
MYGA: These are only incidentally mentioned in this post, but they are inexpensive and use mortality credits. Multi-Year Guaranteed Annuities are like CDs. They are tax-deferred and can be 1035 exchanged into SPIAs (doing so is the reason why DIAs may not be the right thing for most). These are bond alternatives and perhaps more useful in after-tax accounts because of the tax deferral.
SPIA: The gold standard in a good annuity! Simple and inexpensive, they have mortality credits. A Single Premium Immediate Annuity provides income starting within 13 months of a single premium. This is mailbox money, a personal pension. The main risk is inflation causing your annuity to lose purchasing power.
QLAC: I argue Qualified Longevity Annuity Contracts are good annuities for WCI readers. Take $200,000 of bonds from your retirement accounts and turn it into a future income stream. While they don't have rock-bottom prices, they aren't nearly as objectionable as other annuities that are not recommended because of their cost and complexity. It's true longevity insurance with the ability to pay back the premium to your heirs if you die before turning on the income. Since they are so flexible, they can get a bit complicated, but as they were approved by the IRS in 2014, there are a lot of consumer protections built into QLACs.
Which Annuities I Consider Not ‘Good'
Since we are going to learn about good annuities today, let’s briefly mention the not-so-good annuities that pay a high commission to the insurance salesperson.
Variable annuities invest in sub-accounts in funds that look like mutual funds (and not infrequently have expense ratios well in excess of 1%). Indexed annuities credit your account depending on the performance of indexes (which are not infrequently created to perform well on back-testing). Both are complicated, and there are very few indications for either (which I’m not going to talk about right now). They are sold to you because they are complicated and confusing and pay a high commission to the person who sold them to you.
As evidence, in 2022 there were $523 billion worth of fixed annuities sold (which include SPIAs, DIAs, QLACs, and MYGAs) compared to $585 billion of indexed annuities and $2.18 trillion of variable annuities. That's just about the opposite of what it should be in the best interest of the consumer.
Good annuities are not sold to you; you have to go out looking for them because they pay low commissions and the insurance salespeople don’t have the fiscal incentive to chase you down and sell them to you.
What Are the Characteristics of a Good Annuity?
Good Annuities Have Low Commissions
One of the largest complaints about annuities is their high commissions. Indexed and variable annuities pay 6%-10% in commissions to the annuity salesperson. While the money isn’t taken from your account (that is, you don’t see your amount drop by 6%-10%), its cost is nevertheless passed on to you via long surrender periods and through suboptimally funding your account (in order to pay the commission back).
SPIAs (which provide income after a single premium payment) and MYGAs (which are similar to CDs but are tax-deferred) have commissions of 1%-3%, and other good annuities (such as DIAs and QLACs) are between 2%-4%.
QLACs average 3.45%, and they are not “sold to you.” You have to buy good annuities; since they pay low commissions, they won’t be sold. You can buy these good annuities from an annuity salesperson (but be careful that they don’t try to upsell you something that compensates them better) or you can shop and compare rates online.
Good Annuities Have Mortality Credits
Mortality credits are why annuities pay more than bonds. Remember, annuities are bond alternatives and are not to be taken from the stock portion of your asset allocation.
What are mortality credits? Since actuaries know how many people in the mortality pool will die each not year (not who, but how many), they can pay you more now since they know they will be paying fewer people as the years progress. Since people in your risk pool die early, the insurance company knows they can pay you more than they would just based on their long-term investments (of your money). Mortality credits are the increase in payments you receive from annuities because they know the risk pool dies off over time.
Good annuities that have mortality credits include SPIAs, DIAs, and QLACs. Mortality credits are key to understanding good annuities because they are the math behind why annuities pay you more than your bonds.
What Types of Annuities Are ‘Good' for White Coat Investors?
DIAs Are Good Annuities
Deferred Income Annuities (DIAs) are good annuities as they pay low commissions and have mortality credits. With a DIA, you give the insurance company a lump sum now in return for an income stream in the future. The returns you get in the future depend on the terms of the contract and, of course, they are based on how old you are and how long you defer the money. Also remember that DIAs are just for your after-tax accounts (whereas QLACs are for your pre-tax accounts).
I don’t like DIAs right now because you might as well use a MYGA and then 1035 exchange the money in the future to a SPIA without paying taxes. In effect, you can build your own DIA but not actually lock in the annuitization. You get tax-free growth but then optionality in the future of getting back a lump sum or doing a tax-free exchange into a SPIA. In addition, DIAs lack some of the consumer protection features of QLACs (since QLACs were “created” by the IRS in 2014 to provide a longevity annuity for your tax-deferred accounts).
QLACs Are Good Annuities
QLACs are good annuities as they pay low commissions and have mortality credits. QLACs are like a DIA for your qualified accounts. That is, they are deferred income annuities that you can buy in your IRA, 401(k), 403(b), etc.
As the source of the money is a pre-tax account, the money is fully taxable (just like most pensions).
With a QLAC, you can take up to $200,000 and give it to the insurance company in return for a significant income stream when you are, say, 80 or 85 years old. You save in taxes (since the premium payment is not in your account, there are no Required Minimum Distributions) until you turn on the income stream, at which point your taxes increase. You don’t buy a QLAC to decrease RMDs (or pay less in taxes over your lifetime); you buy one to diversify your bond portfolio and for longevity insurance.
For instance, if you take $200,000 worth of bonds in your IRA and buy a QLAC with it, your asset allocation will be more aggressive. But you've now bought an income stream in the future, which will decrease the (eventual) withdrawal rate on your portfolio once the income turns on. This means you own more stocks for longer periods of time, and a QLAC can actually increase what you leave behind to your heirs or charity.
Additional features of QLACs: there are no annual fees, you have the option for single or joint life payout (your spouse will love this), you can take advantage of the returns of premium option (if you die before the income starts, your heir gets the principal payment back), and usually you can change the start date by five years (younger or older) if your medical condition changes. There are cost-of-living adjustment options available, but I have done no research on the topic.
You report QLAC income on IRS form 1098-Q.
Why QLACS Are Good Annuities for White Coat Investors
The average WCIer has oversaved for retirement and usually has a large amount of tax-deferred money. You can take $200,000 (from your bond allocation) and lock in longevity insurance for you and/or your spouse.
Optimally this is money you will never need (because you can continue with portfolio withdrawals in the absence of a future income stream). Think about it this way: if you use bonds to fund the QLAC, you are keeping more in equities to give away to your heirs (because you have them initially and then use less of them up when the QLAC income stream starts).
I like streams of income, and I like diversification. After all, you don’t pay for retirement with your nest egg; you have to pull an income off somehow. And I like the idea of taking some of my bonds and giving them to an insurance company to manage, knowing that I’ll get a better return as a result (because of mortality credits).
Even if you don’t need current income (via a SPIA), consider a QLAC for longevity insurance. QLACs are good annuities and won’t be sold to you. Instead, you need to understand them and go out and hunt them down.
Finally, Dr. Jim Dahle wrote about QLACs in the May 2023 newsletter. He is not as much of a fan of QLACs as I am. I hope you can see that if you replace bonds with a QLAC, you come out ahead and may even leave more behind for your kids. But fundamentally, QLACs are longevity insurance (not as a way to “solve” your RMD problem). I don’t know an 80 or 85-year-old who doesn’t appreciate mailbox money that shows up every month, come rain or shine.
You can only buy $200,000 worth, but if you sell bonds to buy a QLAC (as I recommend), $200,000 becomes a more significant amount when the income stream begins. Diversify your bond holdings and increase their returns (via mortality credit); what’s not to like about that?
[Founders Note from Dr. Jim Dahle: I discuss my thoughts on all things annuity here. QLACs are just DIAs in a retirement account. As Dr. Graham notes, I'm not a huge fan for the reasons he mentions. You can only buy $200,000. It doesn't really solve a real RMD problem. And most people probably don't want or need a DIA anyway. While IN THE VERY LONG RUN, an annuity can outperform bonds, bonds also have their advantages (more liquidity, better early returns, inflation protection with some, don't disappear at your death, etc.). Certainly a low-cost, well-designed DIA/QLAC is reasonable for a WCIer to buy, but most WCIers probably aren't going to want one and almost none will need one. But if you want a DIA for whatever reason, sure, consider the QLAC version. While some SPIAs, DIAs, QLACs, and MYGAs certainly qualify as good annuities, I would stop short of saying ALL SPIAs, DIAs, QLACs, and MYGAs are good annuities.]
Do you have or are you planning to buy an annuity? What kind would you purchase? Do you think investing in a QLAC would be a good move for you? Comment below!