Longevity Insurance
You may have heard of annuities and wonder how they work and if they should be part of your retirement plan.
Are you approaching retirement and unsure of how much of your savings you can safely spend? Do you wish you had a pension to supplement your Social Security benefit? Are you in good health and worried that you’ll run out of money before you run out of time?
If you answered yes to these questions, it may be sensible to convert some of your savings to an annuity when you’re ready to retire.
Annuities can be complicated, have many variations, and some have large and well-disguised fees. They’re not easy to sort out but I’ll try by answering these questions:
- What are they?
- How are they priced?
- Who are they for?
- What else should you know?
What is an annuity?
There are lots of variations but I’m focusing on the simplest and lowest cost type — a single-premium immediate annuity (SPIA). This is the most sensible and I’ll ignore so-called variable and deferred annuities or those attached to whole-life insurance plans — they’re for the salesperson’s benefit, not yours.
With a SPIA, you make a single upfront payment and in return, you receive monthly pay-outs until you die. It’s the opposite of term life insurance where you periodically pay a premium and in return, your beneficiary receives a lump-sum payment when you die.
With life insurance, an insurance company hopes you live forever; with annuities, the insurance company “hopes” for your quick death.
Annuities are best thought of as longevity insurance. You “bet” that you will live a long life and if you do, you will be protected through these lifetime monthly payments. The insurance company “bets” on you living a short life so its profit is maximized.
A SPIA is essentially a pension plan you fund with your own savings, rather than receiving it from a past employer.
How are annuities priced?
SPIA pricing is straightforward as you only need to focus on the payout ratio. This is the percentage of the amount you paid for the annuity that is repaid to you annually in monthly payments. The payout ratio is net of any fees or sales commissions so you can easily compare different insurance companies’ offerings. Note that it is not the same as the implied investment rate of return as that would require knowing how long you live.
The payout ratio is mostly based on your age, but is also dependent on the current level of interest rates and your gender. Men have a shorter life expectancy so they receive a slightly higher payout ratio than women.
For example, the payout ratio for a 70-year old is currently ~8.5%. This means that if a 70-year old purchased an annuity for $100,000, s/he would receive annual payments of ~$8,500 or lifetime monthly payments of ~$708 (a bit higher for men and a bit lower for women).
You would need to live ~12+ years to have been paid back the full amount of your annuity purchase (again, a bit less for men and more for women). The breakeven period is longer if you include the foregone interest. So, in this example, if you thought you would live to age 90, an annuity would be a good bet.
Do you want to check pricing? A quick and simple website is immediateannuities.com.
Who should consider an annuity purchase?
A SPIA may make sense if you are of retirement age, in good health, and want:
- “longevity insurance” to ensure you don’t outlive your money.
- guaranteed income beyond your Social Security benefit.
- more diversification in your retirement assets.
Don’t buy any annuity if you:
- are still working — retirement age is a good time to consider this.
- receive a significant pension from another source, perhaps in addition to Social Security. An annuity is probably redundant as you’d already have a guaranteed source of income.
- believe you have a shorter than average life expectancy.
What else should you consider?
1. Inflation adjustment
You can have your payments adjusted upward for future inflation. This sounds sensible but nothing comes for free and in this case, it means you either pay more to purchase the annuity or your initial monthly payments would be lower than if you opted out of the inflation adjustment. There’s no free lunch.
2. Survivor benefit
You can include a spousal survivor benefit. Again, there’s no free lunch and the value of the annuity is reduced to reflect the greater longevity risk to the insurance company. It may be sensible to include this but you need to assess your individual circumstances, the cost difference, etc.
3. Minimum guarantees
You can ensure that you (really your estate) receives some minimum payback of your original purchase amount. Once again, there’s no free lunch and if you opt for this benefit, your monthly payment is reduced. I don’t see any point in doing this as you’re purchasing this annuity for your lifetime benefit and you should maximize its value to you. However, consumers often like this option because they feel the money won’t be “wasted” if they were to die younger than planned.
4. Purchasing with IRA funds
You can purchase an annuity with IRA funds and this is known as a qualified lifetime annuity contract (QLAC). For the purposes of calculating your required minimum distributions, the amount of the QLAC is subtracted from your IRA balance. This may be a more tax-advantaged option in certain circumstances.
5. Government guarantees
One drawback of all annuities is that they don’t offer a federal guarantee similar to how FDIC insurance protects bank deposits. If the insurance company were to go bankrupt, your future payments would be at risk. Yes, there are state guaranty pools that may provide some protection but you don’t want to test them in your old age and find out how solid they really are. This is a structural defect with annuities and other long-term insurance products and a reason why you should not annuitize all of your savings and you may want to consider diversifying this risk by splitting your annuity purchase between two different insurance companies.
6. Your health
Annuities are for people who have above average life expectancies. Insurance companies understand that and price them accordingly. They’re not a good choice if you’re not confident you’ll fall in the upper half of the longevity range. There are better investment options in those circumstances.
Don’t evaluate an annuity as an investment as it won’t make financial sense; it’s insurance, similar to auto or homeowner’s insurance. In this case, you’re insuring against living a long life.
Do you have questions about whether an annuity makes sense for you? Get in touch to find out about my Retirement-Readiness service.