Using Deferred Income Annuities For Retirement Income

Those approaching retirement are looking for ways to provide lifetime income; a recent ruling from the United States Department of the Treasury has placed renewed attention on the use of deferred income annuities, also known as longevity insurance, in a retirement income plan.

First, A Little Background

Deferred income annuities are generally paid for with a single-premium and income payments commence after a minimum of one year. The recent Treasury ruling allows participants  in a 401K or Traditional IRA retirement account to use the lesser of twenty five percent of their account balance or $125,000 for the purchase of a qualifying deferred income annuity. Income from the contract may be postponed up to age eighty five and will be excluded from Required Minimum Distribution calculations.

The ruling has resulted in an expansion of products designed to provide guaranteed income later in life. While the benefits may be compelling for some, there are distinct advantages and disadvantages of these products.

Including Deferred Income Sources In Your Retirement Income Plan

Deferred income annuities can be incorporated into any of the three broad categories of retirement income plans discussed in our most recent blog post.

  • The Systematic Withdrawal Approach: the income from the annuity augments income that is drawn from the investment portfolio later in life.
  • The Time Based Segmentation Approach: the annuity income can be included in the investment mix of the client’s long term income bucket.
  • Essential Versus Discretionary Approach: a somewhat smaller deferred income can be used to provide additional guaranteed income that will support a client’s essential spending. This essential income “floor” may have eroded in value over time due to inflation.

Advantages Of Deferred Income Annuities

The use of a deferred income annuity may be a cost effective way to mitigate the risk of poor investment performance or living longer than anticipated. In the case where investment performance is not sufficient to support income needs, the client would have an additional source of income available during the later stage of retirement. Should they live longer than expected, the income received from the annuity will continue until death.

A deferred income annuity is relatively cost effective because it takes advantage of mortality credits provided by an insurance company. In short, some people that purchase a deferred annuity will live long enough to receive an income stream, others will not. As a result, the insurance carrier can provide this income stream at a lower cost than with the use of a single premium immediate annuity- the type that begins payments right away. The mortality credit leverage is significant because the income may be deferred for many years. It is important to note, however, that this leverage is diminished when clients use return of premium or refund options in lieu of the single life payment option.

Another advantage may come in the form of providing financial simplicity later in life. Individuals can face increased difficulty in managing investment portfolios as they age. The systematic and automated nature of the annuity income payments can help reduce the need to make decisions surrounding portfolio management and withdrawals. An ancillary benefit could be a decrease in the incidents of theft or elder abuse.

Disadvantages Of Deferred Income Annuities

An obvious disadvantage of the deferred income annuity is winding up on the wrong side of the mortality credit. Those that die prior to receiving an amount of income that is commensurate with their investment will have subsidized the retirement of those that live to an advanced age.

A second disadvantage is the lack of liquidity available in an annuity versus other investment options. Once the annuity has been funded, the premium is removed from available assets and can no longer be used for other purposes.

Having limited capital at retirement is a challenge faced by many retirees, the use of a deferred income annuity further reduces the amount of capital available and will result in an increased reliance on the investment portfolio to generate income. This leaves the portfolio more vulnerable to poor investment results, and may reduce the client’s ability to invest for future growth.

An additional consideration is the lack of deferred annuity contracts that provide inflation protection during the deferral period. That is the period between the time of purchase and commencement of income. This results in the need to estimate the amount of benefit needed many years in the future. Future inflation is uncertain and this type of bench-marking is likely to be inaccurate.

Finally, annuity pricing is based on current interest rates and the lower the rate the more capital is required to provide a future benefit. Deferred income annuity pricing may become more attractive as interest rates increase.

Wrapping It All Up

We believe that any product should be viewed as part of a larger strategy and deferred income annuities are no exception. The ability to exclude deferred income annuities held in qualifying retirement accounts from RMD calculations will help enhance the product’s profile, but that alone is not enough to warrant adding one to your retirement income plan. As with any product, the advantages and disadvantages must be considered in the context of the client’s retirement income plan.

By developing a thoughtful plan to manage expenses and provide income, the decision  of whether to include a given product becomes much easier to make. We would be pleased to assist you in developing a retirement income plan, and welcome your questions or feedback.

John Male, CFP®
The Gassman Financial Group
G&G Planning Concepts, Inc.
The Retirement Maven™
9 East 40th Street, Suite 1500
New York, NY 10016
Tel: 212-221-7067 Ext. 17
Fax: 585-625-0830


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