Many of life’s big decisions are the all-or-nothing kind. Taking a job, getting married, or buying a house have no middle ground. Meanwhile, other big decisions can cause angst because they are irreversible (e.g., children, tattoos). Most of us would pay dearly for some flexibility and optionality when we face these forks in the road.
Decisions about retirement income have, until recently, been on this list of difficult choices between extremes. A person who wanted guaranteed income for life could buy an annuity.1
Traditional annuities are often attractive because they offer fixed, lifetime income along with an extra income boost known as the mortality premium (which we explore on the next page). But a traditional annuity means relinquishing control over your assets, a major drawback when considering heirs and unplanned spending needs. The alternative – drawing retirement spending directly from an asset portfolio – provides retirees control and liquidity but leaves them exposed to longevity risk. To annuitize, or not to annuitize
has thus been the big question for many people thinking about retirement, with trade-offs that are painful and implications that are irreversible. Understandably, few have annuitized.
Now there is a middle ground: longevity annuities. Following new US Treasury Department rules, longevity annuities can be used in qualified defined contribution plans to provide deferred income many years after retirement starts. By deferring payments until a later age, longevity annuities – such as Qualified Longevity Annuity Contracts (QLACs) as they are known in the DC space – offer protection against outliving your assets but cost only a fraction of a traditional annuity. As a result, the majority of a participant’s wealth remains in their portfolio and under their control. By bundling a liquid bond portfolio to generate income in the earlier retirement years with a QLAC that kicks in later, participants can offload their longevity risk and still have full control over most of their assets as they enter retirement.2
This “bundle strategy” also helps alleviate the concern about having all your eggs in one basket, since only a small fraction of your wealth would be exposed to insurance contracts with concentrated counterparty risk.
This kind of bond-QLAC bundle strategy looks even better when you consider another factor: insurer fees and other frictional costs. As we will explore, these costs impact a longevity annuity differently than a traditional annuity. This different impact means that you can expect a higher income level from a QLAC-based approach than from either of the strategies at the extremes of the spectrum. And when a quantitative estimate of liquidity value is applied, the effective
income level of the bundle strategy may even further exceed the traditional annuity or the asset-only approach. In this paper, we quantify the benefits of the bond-QLAC bundle and show that, for some, the retirement income decision may now be a lot easier.