By: David Richardson
David Richardson is a Senior Economist at the TIAA-CREF Institute. He serves as the Institute’s resident expert on financial security products and strategies, helping to identify research needs and coordinate research initiatives.
US federal law requires retirees to annually withdraw a minimum amount from their retirement accounts after the age of 70 ½. [1] This is driven by a tax rationale: since pension contributions are generally tax-deferred, Required Minimum Distribution (RMD) rules require that taxes should be paid on pension benefits during old age. Yet a criticism has been levied at RMD rules, namely that they may prejudice good retirement policy. To the extent that some households are required to draw down their pension wealth too soon, this increases the risk that they will outlive their resources.
Since the basis of the RMD rules is tax rather than retirement policy, it is not surprising that the tax regulations focus on revenue collection. Nevertheless, sensible changes in RMD regulations can strengthen retirement policy by making it easier for households to coordinate short-term income needs with longer-term retirement concerns.
To this end, the US Treasury’s Office of Tax Policy recently made it easier for households to plan for late-life needs by approving new Qualified Longevity Annuity Contract (QLAC) rules. These rules permit retirees who convert part of their pension accounts into deferred annuities to use 25% of their retirement savings (to $125,000) to buy guaranteed income protection which can be delayed to age 85. An interesting aspect of these new rules is that the retirement assets used to buy the QLAC are excluded from RMD calculations.
As an example, consider a retiree age 70 having $500,000 in a tax-favored retirement account. Such an individual could use $125,000 of the account to buy a Qualified Longevity Annuity Contract, in turn reducing the asset base on which the RMD rules apply. In effect, the retiree can tilt her retirement income distribution to older ages, providing her with enhanced longevity protection. Additionally, the QLACs can also provide for principal protection, spousal benefits, cost of living adjustments, and estate protection.
Recent research has confirmed that RMD rules in fact do strongly shape retiree income distributions. Evidence from a one-time suspension of the RMD rules in 2009 indicates that about one-third of eligible older households did take advantage of the one-year holiday. In particular, younger retirees, those having more retirement resources, and those who took annual (versus monthly or quarterly) RMD payments, were most likely to suspend their distributions. When people were asked why they did (or did not) suspend their RMD payouts, two responses stood out. First, most (85%) of those who did suspend RMD payouts cited a wish to “preserve more money for older ages.” Second, 60% of those who did not suspend their RMD payments said they viewed the RMD schedule as a good guide for how they should be drawing down retirement assets.
The reality, of course, is that the RMD schedule is the product of tax policy, rather than a carefully-designed optimal payout schedule appropriate for each aging household. While it may be a reasonable rule of thumb for drawing down retirement assets for some, for many others – particularly the risk averse – that strategy will be suboptimal and it can lead to very low income at advanced ages.
In sum, RMD rules can and do have a powerful impact on older persons’ pension drawdowns. Coupling this finding with evidence from behavioral finance on “endorsement effects,” it would appear that the new QLAC rules will be helpful in strengthening retirement security goals while keeping in mind tax policy objectives.
[1] These include traditional individual retirement accounts, simplified employee pensions, and most employer-sponsored retirement plans.
This piece was originally posted on June 30, 2015 on the Pension Research Council’s curated Forbes blog. To view the original posting, click here.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.
