How Does a Deferred Income Annuity Work?
The Annuity Man
Deferred Income Annuities (DIAs) are continuing to grow in popularity because they are a personal pension plan with you determining when the payments start. However, as with all annuity types, there is an education gap that needs to be filled in order for you to make an informed decision.
So when I receive the typical “Should I buy a Deferred Income Annuity” or “Are Deferred Income Annuities a good investment?” type questions, the correct answer is maybe. It all depends on your specific situation and what you are trying to contractually achieve.
Roman SPIA Lineage
DIAs are the first cousin of Single Premium Immediate Annuities (SPIAs). SPIAs were first introduced in the Roman Times as a lifetime pension payment for the dutiful Roman soldiers and their families. That’s where the annuity game started.
SPIAs and DIAs are pretty much the same structure. No market attachments. No annual fees. No moving parts. Low (hidden) commissions paid to the agent. You can explain how a SPIA and DIA work to a 9 year old, and they would fully understand the strategy (no offense to 9 year olds!). Both SPIAs and DIAs are classified as fixed annuities and are issued by a specific life insurance company.
The primary difference between a SPIA and a DIA is the income start date. SPIAs can have the contractual lifetime income stream start as early as 30 days from the policy issue date, and up to a 1 year deferral. DIAs can have income start as early as 13 months from the policy issue date, and the income can be deferred as far out as 30 to 40 years (depending on your age and the carrier).
Both SPIA and DIA lifetime income streams are primarily priced on your life expectancy (“expectancies” if set up joint) at the time you start the payments. Interest rates play a secondary pricing role. The income stream is a combination of return of principal plus interest.
SPIAs and DIAs can be used in Traditional IRAs, Roth IRAs, and non-IRA (i.e. non-qualified) type accounts. The contractual guarantees are the same regardless of the account type. The only difference will be the taxation of the income.
Deferred Income Annuity benefits are numerous. I have listed the major ones below.
*No Annual Fees
*Simplistic and efficient design
*Large carrier participation
*100% principal protected
*Income guarantees can be customized
*Functions like your Social Security payments
*Can be used in all account types
*COLA (Cost of Living Adjustment) increases can be attached
*Low commissions to the agent
*Carrier is on the hook to pay regardless of how long you live
No product is perfect, and DIAs do have their contractual limitations. It’s important for you to be fully aware of the realities of the policy before making a decision. Below are the main DIA limitations, in my opinion.
*No accumulation value
*No market growth potential
*Payments are primarily based on life expectancy
Customize The Income
DIA contractual income streams can be customized to achieve your specific goals. You can structure the policy to pay for a “Single Life", “Joint Life,” or a "Period Certain." You can choose the exact start date (to the day), and you can make sure that 100% of any unused money in the policy goes to your listed beneficiaries when you die. You can also structure the payments to pay for a specific period of time (i.e. “Period Certain”). I guess you could call DIAs a "guaranteed future income annuity"…because that’s what they do.
The bottom line is that you structure a DIA exactly the way you want it to work. “Life or Joint Life with Installment Refund” and “Life or Joint Life with Cash Refund” are 2 of the most popular structuring choices. Installment Refund attached to a lifetime income guarantee means that when you die, the remaining money in the account goes in payment form to the beneficiaries until the money is exhausted. Cash Refund attached to a lifetime income guarantee means that when you die, the remaining money in the account goes lump sum to the listed beneficiaries. You can also structure the policy so that if either of you (i.e. Joint Life) dies before you start receiving the payments, 100% of the money will go to the policy beneficiaries.
Either way, the annuity company is on the hook to pay regardless of how long you live and will not keep a penny of your money under any circumstance. Isn’t that what most people want?
QLAC = DIA
The newest annuity type came out in 2014, and was introduced by the Treasury Department and the IRS to be used in qualified accounts like Traditional IRAs and some 401k type employer plans. That product was a DIA structure called a Qualified Longevity Annuity Contract (QLAC). It’s a DIA, but with its own specific rules.
In 2020, the QLAC funding rule is the lesser of 25% of your total IRA type assets (non-Roth) or a $135,000 lump sum. You can structure the payments “Joint” with your spouse or partner, and have the payments start as soon as you want, and as late as age 85. Most QLAC payments I see start at age 75 or 80...but it's your call. The money you place in a QLAC is not used to calculate your RMDs (Required Minimum Distributions), so there is a potential for some tax savings as well.
The most popular QLAC income structure is either “Single Life with Cash Refund” or “Joint Life with Cash Refund.” Both guarantee a lifetime income stream with the contractual assurance that 100% of any unused money goes lump sum to the beneficiaries of your IRA. That is the death benefit of the QLAC policy.
QLAC income coming out of a Traditional IRA is taxed at ordinary income levels.
AKA: Longevity Annuity
DIAs are also referred to as “longevity annuities” because they contractually solve for longevity risk (i.e. outliving your money). If you are planning for guaranteed income/retirement income and looking for higher payouts at a future date, then Deferred Income Annuities are worth exploring further.
In addition to finding the highest contractual payout by using an objective annuity calculator that quotes all carriers, you also have to look at the claims paying ability of that issuing life insurance company as well. Guaranteed lifetime income is only as good as the company backing up that guarantee.
Whether it’s a DIA or a QLAC, future income can help combat potential inflation and provide additional funds to enhance your retirement lifestyle. You’ve earned the right to live well in the future, so you might want to make sure contractual guarantees are in place to make that happen.