longevity insurance is the latest tool designed to relieve Baby Boomers’ anxiety about outliving their income. This innovation now is offered by Hartford Financial Services and MetLife, and other insurers are developing their own versions.
You know the problem. A 65-year-old today has about a 50% probability of living past 85, and a 34% chance of living to 90. The odds are higher for women. Yet, most financial plans do not plan for long enough lives. For a married couple, to be safe a plan should have at least one spouse living to age 100. Even those that do plan on long lives have their results depend on assumptions, such as inflation and investment returns. If reality is worse than the assumptions, the retiree could run out of money.
To deal with this hazard, longevity insurance was developed. A more technical term for the contracts is advanced life deferred annuity. The product is simply an annuity with a twist or two. So, despite the name it is not really insurance with a guaranteed payout; it is an annuity.
With longevity insurance, the policy owner deposits a lump sum with an insurer. The marketing is targeted at people ages 60 to 65, but the deposit can be made at any age. The insurer agrees to begin making payments when the owner turns a certain age, usually 85. Unlike other deferred annuities, when the contract is purchased the insurer tells the owner exactly the amount of the future payments.
This makes the policy a reversal of the traditional deferred annuity in which the insurer tells the owner the interest rate that will be credited to the account each year. Only at the end of the accumulation period does the insured learn the amount of the payments the contract will generate. With a traditional immediate annuity, the owner is told the amount of the payments, but the payments begin within a year. With longevity insurance, the amount of the payments is guaranteed, but the payments won’t begin for a couple of decades in most cases.
For example, if a 65-year-old man recently deposited $10,000 with MetLife, the insurer would guarantee to pay $665 monthly beginning in 20 years. The payments are guaranteed to continue for life, no matter how long that is. That comes to $7,980 annually. If the owner lives another five years the total payouts will be $39,900. If he lives 10 years after the payouts begin, the total received will be $79,800.
That sounds like a good deal. If the owner had invested that $10,000 for 20 years and returned 7% annually, he would have a nest egg of $38,670. There is no guarantee he will earn that 7%, while the policy payments are guaranteed.
The idea behind using longevity insurance is that an individual divides the retirement portfolio into two portions. One portion is managed to pay for expenses through age 85 or so. A relatively small portion of the portfolio is used early in retirement to purchase longevity insurance that will fund the post-85 period of retirement if the owner lives beyond Life Expectancy. In addition, longevity insurance allows the rest of the portfolio to be invested for higher returns since the owner knows there will be guaranteed payments after age 85 if the investments do poorly.
As with all other insurance products, there are trade offs to consider.
One trade off is that there are no payments to beneficiaries. If the insured does not live to the payout age, the insurer keeps the money, as is the case if the owner dies after receiving payments for only a few years. The insurer takes the risk that the owner lives to a very old age, while the owner and his heirs take the risk he won’t. In this respect it is like auto or home insurance. If you never have a claim, the only benefit from the policy is the security of knowing that it is there if you need it.
To counter this drawback, insurers are adding “return of premium” options, but this feature raises the cost by almost 50%. The added cost largely takes away the benefit of investing with the insurer instead of in a traditional annuity or in a taxable account.
The policies also have no inflation protection. The monthly payout at age 85 might seem like a lot of money today, but after 20 years of 2% inflation its purchasing power will be close to half today’s purchasing power. The policies are starting to offer inflation indexing. Again, that comes at a cost, which can be considerable. Also, the policy might state that the inflation indexing kicks in only after the payments begin. The erosion of purchasing power during the 20-years of deferral is not covered.
Another disadvantage is the opportunity foregone. By purchasing a longevity annuity, you lock in today’s investment returns. If another long bull market begins in a few years or interest rates rise, you would have been better off investing the money on your own than buying the policy. Of course, an extended bear market means you come out ahead and the insurer has to worry about how to make up the difference.
Longevity insurance generally requires a lump sum premium instead of payments over time. The policies are starting to offer a multi-year premium option. That also increases the cost, because the insurer does not have your money to invest the entire period.
Because the policies are new and only a few insurers offer them, sales commissions are 5% to 7% of the premium. That cost essentially comes out of your future income payments.
Some advisors believe the disadvantages will be reduced and longevity insurance will be worth a look in a few years after more insurers offer them. If the policies become popular, the competition will bring down commissions and some of the costs. Also, as insurers are more experienced with them costs probably will decline.
Until then, compare longevity insurance with the alternatives.
One option is to purchase a traditional deferred annuity. These generally have a guaranteed interest rate of only about 3% annually. But they usually earn about the same rate as the yield on intermediate bonds, and there is the potential for the return on the account to rise if market interest rates rise. The deferred annuity also allows you to designate beneficiaries during both the accumulation and payout phases. The investment is not lost if you do not live to cash it in.
Another option is to designate part of your portfolio as money you won’t touch until age 85. You can invest this money more aggressively than the rest of your portfolio, knowing that you won’t need it for 20 years. You still do not want to take high risks with the portfolio, but you can take a more growth-oriented approach than with the rest of your portfolio.
Yet another option is to use one of the payout strategies we discussed in last month’s Cash Watch. These strategies allow you to invest in a diversified portfolio for the long term and adjust annual payouts based on either changes in the portfolio or on changes in your spending over time.
A couple of related strategies are in this month’s Cash Watch.
Longevity insurance has potential and will meet the needs of some retirees. But consider its trade offs and the alternatives before becoming an early adopter.