Editor’s note: This is the third in a series about helping your clients prepare for and manage the distribution phase. Earlier articles are here and here.
As discussed earlier in this series, there’s a crucial need for greater emphasis on tax planning and investment options for clients who are living longer, especially high-net-worth individuals. The distribution phase is critical and can mean the difference of hundreds of thousands or even millions of dollars in lifetime wealth for your clients.
But what strategies should advisors consider for investment options and Social Security to maximize clients’ savings?
Below, we explore three ways to build strong and reliable retirement income streams and highlight lesser-known options available to clients.
1. Building a retirement income stream with annuities to decrease longevity risk
Aside from Social Security, few of today’s workers will have a guaranteed income source like a pension. Many retirees may be overspending or underspending based on their age and other factors.
However, an increasingly attractive solution Wall Street offers is annuities. Companies like BlackRock are introducing new annuity-like products in 401(k) plans, designed to allocate a portion of savings into vehicles that provide guaranteed lifetime income.
It’s a reasonable idea as building a strong retirement income stream is crucial for financial stability in retirement. Certain types of annuities can be a valuable part of a retirement income plan, alongside sources like Social Security, portfolio income and capital gains. The recent significant rise in interest rates has made some income annuities more appealing.
According to Barron’s, income annuities are yielding the most since 2009, on average, thanks to a big bump in interest rates since 2020. Immediate-income annuities now average a 7.02% payout, up from 5.7% in May 2020, as reported by the CANNEX Payout Annuity Yield Index. For example, placing $100,000 into such an annuity could yield approximately $620 in monthly income immediately, guaranteed for life across various options including single-life and joint-life annuities.
These products provide retirees a reliable source of income that is guaranteed for life, which can alleviate uncertainty and financial stress during retirement years. Simply, a basic income annuity shifts the risk of outliving your assets to an insurance company, guaranteeing payments for life regardless of market performance. Additionally, combining Social Security benefits with lifetime annuities can create a predictable income stream that covers essential expenses and eases any fear.
According to Barron’s, to determine how much you should put in an annuity, work backward: Add up your monthly essential expenses and then subtract the income you expect from Social Security and a pension, if you have one. The difference is the monthly income you’ll need from an annuity.
Pro tip: Consider the income requirements in retirement and how Social Security and a lifetime annuity can meet most of those income needs, particularly for lower-net-worth clients who have a realistic fear of running out of money.
2. Maximizing Social Security
An interesting strategy Morningstar suggests is delaying Social Security until age 70 as a reliable method to secure lifelong income without requiring an external annuity or at least increasing guaranteed income and thereby driving down the need for the annuity. By waiting until 70, the benefit could increase by approximately 76% compared to claiming at age 62, which locks in benefits about three-quarters lower than those at age 70.
Pro tip: Put another way, if you claim early, you lock in benefits that are about three-quarters less than they would be at age 70. Some people think you can claim early and then get a benefit bump at full retirement age, but it doesn’t work that way.
3. QLACS could make sense to decrease RMDs and create income
You must start taking RMDs from your IRA, 401(k) plan or other qualified retirement plan when you reach age 73. A Qualified Longevity Annuity Contract (QLAC) could be a good way to avoid some of these as the money in a QLAC is excluded from plan assets on which RMDs are calculated.
The SECURE 2.0 Act allows individuals to transfer up to $200,000 from a qualified retirement plan or IRA to a QLAC, deferring RMDs until age 85. The amount will be adjusted for inflation in future years. This new legislation simplifies purchasing these pension-like annuities, enabling more deferred taxes and increased retirement income from 401(k)s, rollover IRAs, or similar accounts.
Previously, QLACs were limited to $125,000 or 25% of the IRA account, whichever was lower. Now, the cap is $200,000 with no percentage limit. Higher interest rates mean QLAC payouts can be 100%-250% more compared to December 2021.
Delaying RMDs is just one advantage. More importantly, you’ll secure a larger stream of income that will last your lifetime. You can purchase a QLAC at any age and you choose when to start receiving a stream of monthly lifetime income, but it must be by age 85 at the latest. The sooner you buy a QLAC, the more time you have to build up the principal, leading to a larger payout in the future.
Remember that with a QLAC, the purchaser gives up control of the principal, exchanging it for a future income contract with an insurer. Individuals can opt for an individual or joint lifetime payout, with the latter continuing until the second spouse dies, as required by IRS rules. If they choose the cash-refund option, beneficiaries receive a lump-sum payout of any remaining initial deposit, though this often reduces future monthly payments.
Payout amounts vary, but can often range from 7%-15% of the QLAC premium annually, depending on when the payments start. As an example, if someone invests $200,000 in a QLAC and the payout rate is 10%, they could receive $20,000 per year once payments begin.
Pro tip: The SECURE 2.0 Act also allows a “return of premium” feature, ensuring the purchase amount, minus payouts, goes to a beneficiary upon the investor’s death. This offers dual tax benefits: exclusion of $200,000 from the RMD and deferred QLAC income.
In summary, for many advisors, the focus on accumulation planning only tells half the story. There needs to be an equal focus on distribution planning, with consideration towards building strong retirement income streams with strategic investment options. Our strategies need a more informed approach that guarantees income for a client’s life—no matter how long that is.