Understanding Longevity Annuities
Posted by Frank Napolitano on July 28, 2015
As I promised in my June blog, this month I’m focusing on a topic covered during the National Association of Personal Financial Advisors Spring conference: longevity annuities. (Full disclosure: Sensible Financial® does not sell insurance. Sensible Financial is a fee-only financial planning firm).
Before getting into the specifics of longevity annuities and how they might fit into a retirement income plan, a few words about annuities in general (“annuity” is still a four-letter word to many people).
- What is a life annuity? A life annuity is a contract between a buyer (individual) and a seller (insurance company) in which the buyer receives lifetime payments, either immediately or starting at some point in the future, in exchange for a lump sum payment.
- What is the difference between a life annuity and a variable annuity? A variable annuity (VA) is basically a mutual fund (or collection of funds) with some added insurance and financial guarantees. These annuities are by far the most popular type of annuity sold in the United States, accounting for about 70% of annual sales. I say “sold” because few people actively seek out a VA. VAs are popular with insurance salespeople due to their high commissions. VAs typically have high expenses and surrender charges (fees charged to the buyer for several years after purchase if she decides to withdraw the money). Poor performance is frequently the result.
- NOTE – When most people say “I hate annuities!”, they really mean to say “I hate variable annuities!”
- What does it mean “to annuitize”? To annuitize simply means to exchange assets for a guaranteed lifetime income. When you purchase an immediate life annuity (an annuity that starts payments right away) you have “annuitized”. If and when you convert a VA into income, you also will have “annuitized” (until that point a VA is simply a savings and accumulation vehicle). Interestingly, only about 1-3% of variable annuities are ever annuitized.
- NOTE – A rather confusing fact about all this annuity business is that the words “annuity” and “annuitize” mean very different things. It would be far better in my opinion if we used different words, one for the insurance product and another for the process of converting savings into guaranteed income. But that’s not the case. Therefore, it’s important to remember that annuities do not necessarily have anything to do with annuitization.
With a longevity annuity (sometimes called “longevity insurance” or a “deferred income annuity”) you pay the insurance company now for the promise of a guaranteed lifetime income starting sometime in the future (buyers can usually defer up to a maximum age of 85). So a longevity annuity is just a life annuity that starts at some point in the future. But if you could buy guaranteed income starting now, why would anyone wait until tomorrow (or twenty years from now) to start receiving income?
The primary advantage of a longevity annuity (relative to an immediate life annuity) is the cost. It turns out to be (much) less expensive to buy guaranteed income that starts far in the future than one that starts today. That’s because by the time the annuity starts paying out a number of people who purchased the longevity insurance (annuitants) will have died. The insurer has to make payments only to those annuitants who are still alive. Therefore, the cost of insurance is much less than for an immediate annuity, where the insurer must make payments to a larger pool of longer-expected-lifetime annuitants.
So while life annuities in general can help mitigate longevity risk, i.e., the risk of outliving one’s assets, by pooling people’s assets and guaranteeing income for life, longevity insurance might actually mitigate that same risk at a lower total cost to you.
Importantly, longevity insurance is not for everyone. What are some of the drawbacks of this type of insurance?
- If you die before the future payout date, you will forfeit your entire premium (there are guarantees you can add to an annuity that protect against this, but you pay for them).
- There is currently no product that protects against inflation between the time the annuity is purchased and when the payout begins. You have to estimate inflation before you purchase the annuity and inflation is very hard to predict. So if you assumed 2% inflation over a twenty-year period but instead inflation was 4%, your future purchasing power would be 30% less than you had planned.
- If you are not in good health or longevity is not in your family, buying a life annuity that may not start until after your expected lifetime may not be prudent.
Longevity insurance is a potentially useful solution for many people, especially those who are concerned about outliving their financial assets. Sensible Financial has a number of ways to analyze how longevity insurance might fit into your financial plan. If you are interested in having a discussion, please contact your advisor.