When planning for your later years, three financial risks must be managed: market risk (the market might go down), inflation risk (prices might go up), and longevity risk (you might outlive your savings).
The last one may sound like an oxymoron since it refers to the potential problem of living a long life, which most people typically prefer. However, longevity could pose a problem if you don't have enough money set aside for those years.
Annuities were designed to address this issue by providing guaranteed income, potentially for as long as you live. The newest kid on the annuity block, the deferred income annuity (DIA), is especially tilted toward protecting against longevity risk. And new Treasury Department rules now make it workable to purchase a DIA within an IRA or 401(k) plan. So, should you consider one?
What is a deferred income annuity?
The deferred income annuity, introduced in 2011, goes by a variety of names, including longevity annuity, advanced-life deferred annuity, and longevity insurance.
Whereas an immediate fixed annuity might be purchased by someone at age 65 and begin paying, as its name suggests, immediately, a deferred income annuity is designed to begin paying much later — at age 75, 80, or even 85. The ideal candidate is someone who is confident about having enough income to last to the point at which the DIA would kick in. Knowing that if you outlive the mortality table's prediction, you won't outlive your income can provide peace of mind.
Since income from a DIA isn't scheduled to start flowing until years down the road, the initial cost is far lower than with an immediate annuity. For example, according to Vanguard, a 65-year-old man could buy an immediate fixed annuity that pays $1,000 per month for $171,981. To receive that same amount of income starting at age 85, it would cost only $26,894 today. (Examples generated at www.incomesolutions.com.)
Some DIA issuers offer inflation riders, a return of premium death benefit for heirs, and other options — all, of course, at the cost of lower monthly income.
Resolving an RMD issue
The concept of creating a guaranteed income stream that begins at age 75 or later can sound appealing, but buying a DIA within a 401(k) plan or IRA used to present a problem. Required Minimum Distribution rules force account holders to begin liquidating such accounts at age 70½.
However, the Treasury Department solved that problem in July 2014 by exempting money used to buy a DIA and future DIA distributions from RMD rules. One caveat: you may not purchase a DIA via a Roth account or an inherited IRA. Another rule limits the DIA premium to the lesser of $125,000 or 25% of the value of either (1) a workplace plan account, or (2) the total value of all IRAs you own. You must also begin receiving DIA distributions no later than age 85.
Does a DIA make sense for you?
As with all annuities, buying a deferred income annuity involves a tradeoff. Your monthly income is guaranteed, but for the highest payout (single life), you risk dying too soon to recover even your premium. Besides, you may be able to generate more income by investing the money on your own while maintaining access to the principal and being able to leave the money to your heirs.
As with any retirement income decision, figuring out the best course of action requires running some "what-if" scenarios.
Consider the earlier example of a 65-year-old man spending $26,894 on a deferred income annuity that will pay him $1,000 per month starting at age 85. What if he invested that money instead? Assuming a 7% annual return, he would have $104,071 by age 85. Vanguard says an 85-year-old man investing that sum in an immediate annuity today would receive $1,210 per month.
The downside? He'd have to accept market risk for the next 20 years, meaning he might not be able to generate that 7% annual return. This scenario also assumes he has $26,894 available to invest in a tax-free account, such as a Roth IRA.
The key question is how much peace of mind do you want or need? If you'll sleep better knowing that at some future age you will have a certain amount of income, a deferred income annuity might be right for you. The new rules allowing you to fund a DIA with money you otherwise might have had to withdraw sooner (due to RMD rules) may just be icing on the cake.
On the other hand, if you are comfortable accepting some market risk in exchange for the potential to generate even higher future income — importantly, all the while maintaining access to your principal — a deferred income annuity may not be right for you.