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Square Peg QLACs Can’t Seem to Fit in 401k Fiduciary Round Hole

Square Peg QLACs Can’t Seem to Fit in 401k Fiduciary Round Hole
August 04
00:03 2015

When we last visited these product orphans late last year, (see “Why Longevity Annuities aren’t as Popular with 401k Fiduciaries as Regulators Think,” FiduciaryNews.com, December 9, 2015), we tentatively concluded they were circles-2-1546838_getty_images_royalty_free_300most likely a solution looking for a problem, but held out hope pricing might be their salvation. With now a full year of availability under its belt, many are concluding that, like the ill-fated MyRA, the QLAC may be headed for the same category as the Edsel. It’s beginning to look as though our earlier article proved correct when it predicted a Qualified Longevity Annuity Contract (QLAC) was “a Catch-22 that would make Joseph Heller proud: If you can afford it, you don’t need it; and if you need it, you can’t afford it.”

“Frankly, at the moment, the longevity contracts I have looked at are too expensive,” says Paul Ruedi, CEO of Ruedi Wealth Management, Inc. located in Champaign, Illinois. “That is, a client can build a passive, balanced portfolio and have a high probability of having a higher income down the road compared to what they can get with a QLAC. Not only that, considering a standard QLAC stops providing income when the investor dies, the heirs will receive nothing. I know it is possible to buy QLAC contracts in other formats that can, but using the standard one person life, the heirs get nothing. If an investor uses the same money to invest, not only do they end up with a plan that will have a high likelihood of delivering more income down the road, they have a reasonably high probability of leaving a significant sum of money to their heirs.”

Initially the idea of guaranteed income – the primary promise of QLACs – sounded quite enticing. “Longevity annuities are similar to ‘target date funds’ where they are set to pay out at a specified time,” says Robert Palidora, a financial consultant at AXA Advisors, LLC in Bala Cynwyd, Pennsylvania.

The devil, however, is in the details, and it is those details that go a long way towards explaining why these alleged income-oriented saviors remain unpopular with plan sponsors. Palidora says one of the main impediments to QLACs is they aren’t portable. “You are stuck being housed within that plan,” he says. “I can see that as a detriment for the Plan provider, they have a fiduciary responsibility to benchmark the plan fees every few years. If they want to move to a new provider they have to leave those assets with the original plan. We found that the clients that have asked about them aren’t interested because of the reasons I stated above.”

The details get even more troubling when one considers the needs and wants of retirement savers. “The basic problem with longevity annuities is that they require people to commit money to an annuity,” says Chris Chen of Insight Financial Strategists LLC located in Waltham, Massachusetts. “Commitment is difficult for seniors. It makes sense if you expect to run out of money in the 80-85 timeframe to have an alternative source of revenues. However, if you have that predicament there is good chance that you will have trouble in the shorter term. Springing for a longevity annuity only compounds the shorter term issues. Furthermore, longevity annuities do not provide great returns. Most investors should be able to do at least as well without them.”

Ruedi took a look at an actual QLAC quote and compared it to reasonable balanced alternatives. “What I did was use a 60 year old male who buys $5000 of lifetime income starting at age 85,” says Ruedi. “I looked at three estimated longevities (90, 95 and living to 100). I found an estimate of $5000 income at age 85 purchased at age 60 for $100,000. I wish I knew if that quote was reasonable.”

He then went on and completed a Monte Carlo simulation on the relevant figures. “Here are some details on why I claim QLAC’s are too costly,” says Ruedi. “I found it very interesting. This assumes I am correct about the estimated income for the QLAC and that a contract that buys $5000 in future income means 25 years from now the income is $5000 and not an inflated number. I ran a simulation using a global 60/40 allocation with thirty basis points expense. A 60 year old buys $5000 per month lifetime income to start at age 85 for $100,000 (that was an estimated quote for what $100,000 would purchase in this example). I compared that to investing the $100,000 [at 0.30% internal cost] in the 60/40 global allocation until 85 and looked for a high probability of successfully having more than a $5000 a month income with the QLAC.”

What Ruedi discovered was that, for the cost of the QLAC, the retirement saver had a very high probability of meeting or exceeding the income stream with a very good chance of recovering the full initial investment.

Here’s what he found if the person lives until the age of 90: “There is an 84% chance of a monthly income of $8,333 vs. the $5000 for the QLAC. Also, 75% chance of leaving $150,000 (actual dollars) to those left behind.”

For someone living to the age of 95, Reudi found: “There is an 88% chance of having a monthly income from investments (spendable) of $5,000. This is the same as the QLAC. Except that there is a 50% chance of leaving his heirs $978,000 and an 85% chance of leaving heirs the original $100,000 invested.”

Finally, Ruedi looked at the case where the individual lives to the age of 100: “There is an 81% of having the same spend ability as the QLAC at $5,000 per month but again, there is a 50% chance of leaving $1,173,000 to heirs and a 75% chance of leaving heirs $187,000.”

Ruedi is aware is analysis is based on a method with limits (Monte Carlo) and the actual outcome might be even more favorable for balanced investing. He says, “This of course is based on set it and forget it simulations, like anyone who has worked with simulation for years can tell you, one would never set it and forget it and that even bad draws can exceed expectations if modifications are made when a plan becomes underfunded.”

Finally, this analysis is based on the one QLAC Ruedi was able to price. “Maybe there are better priced QLAC’s out there,” he say, “but I still think investors will find that while the idea of the QLACs in a 401k makes intuitive sense, until they a priced lower… (which of course only means the insurance companies will have to be willing to make less). Insurance companies know what they are creating with such contracts. They understand that when they look at the probabilities of the distribution of outcomes of the managed premiums, it is the insurance company that knows a lot more than the buyers. The bottom line is the guarantees insurance companies provide are way too expensive. I look forward to more favorable QLAC’s eventually.”

While many might find the numbers in this analysis a bit cumbersome, there must be a reason why QLACs, like the MyRA, have not captivated the market. Why aren’t they as popular as expected? Michael Taylor, founder of Cedarcrest Capital LLC in San Antonio, Texas, says, “The main answer to your question of why they are not popular is that they’re not good investment products.”

Are you interested in discovering more about issues confronting 401k fiduciaries? If you buy Mr. Carosa’s book 401(k) Fiduciary Solutions, you’ll have at your fingertips a valuable reference covering the wide spectrum of How-To’s every 401k plan sponsor and service provider wants and needs to know.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada. His new book Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort is available at your favorite bookstore.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

2 Comments

  1. Curtis Cloke
    Curtis Cloke August 11, 12:09

    Unfortunately this article is flawed. The quote reported and used in this case study is grossly under reporting actual income guarantees available in today’s QLAC market place. I did a quote today for a male participant at age 60 with a single life only. The monthly income amount is $ 5,989 monthly, almost $12,000 more per year than the quote utilized in this article. Adding a cash refund benefit did lower the payout to $4096 monthly, but in this situation, the assets are not gone if the participant does not live long enough to receive an income stream to recover the initial investment. The other reason this study is flawed is it misses two very relative facts that must be considered in the math and science when back testing such outcomes. 1) For especially the higher taxed individuals, you must calculate the tax savings of delaying the RMDs from 70 1/2 thru age 85. When back testing the math, the RMDs must be based on what will be required as a distribution had this $100,000 been left in the 401k plan or in the IRA, growing in the market as defined. In order to do the accurate math, you must inflate the value of the $100,000 when calculating the excess RMDs based on what these QLAC dollars would have been worth not converted to the QLAC. Once you consider the tax-drag of the avoidable early taxes that would be required without the QLAC in excess RMD distributions, plus the nearly $6,000 monthly income flow guaranteed at age 85 from the QLAC without a fee-drag, stress of “sequence of return risk” and now lower required distribution rates are necessary from the remaining investable assets once the QLAC income begins during periods beyond age 85, the math shows that the performance “net of tax” and “net of fee-drag” is not inferior. It lowers distribution rate risk at a time most important to any retiree who may live well into their 90s. In regards to custodians allowing these contracts into their plans and manufactures developing broader options and competitive rates, this will be important to the progress and acceptance of these options. Lastly, in our studies, QLAC contracts generally provide greater guaranteed income benefit to retirees than the GWB rider products massively promoted and available within the 401k space. This prominently due to the fee-drag of such GWB based riders inplan.

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