Longevity Insurance
Should an annuity be part of your retirement plan?
Are you of retirement age and unsure of how much you can safely spend each year? 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 three questions, it may be sensible to convert some of your savings to a lifetime annuity.
Annuities can be complicated and may have large and well-disguised fees. I'll simplify them 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 only focusing on the simplest and lowest cost type — a single-premium immediate annuity (SPIA, aka, lifetime annuity). 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.
A SPIA is essentially a pension plan you purchase with your own savings, rather than receiving it from a past employer.
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. If you “lose” the bet, well, you’re dead but at least you didn’t run out of money.
How are annuities priced?
SPIA pricing is straightforward as you only need to focus on one number — the payout ratio. This is the percentage of the amount you paid for the annuity that is repaid to you annually (typically in monthly payments). The payout ratio is net of any fees or sales commissions so you can easily compare different insurance companies' offerings. This is not the same as the implied investment rate of return as that would require knowing how long you live.
A SPIA — as with term life insurance — is a commodity offering and the payout ratios should not vary much across different insurance carriers.
The payout ratio is mostly based on your age, but also depends on the current level of interest rates and your gender. Men have a shorter life expectancy so they receive a slightly higher payout than women. And, the older you are at the time of purchase, the higher your payout.
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).
In that example, you’d need to live ~12+ years to have been paid back the full amount of your annuity purchase. The breakeven age is longer if you include the foregone interest. So, in this case, if you thought you would live to age 90, an annuity would be a good bet.
Are you curious about pricing for different ages? A quick and easy-to-use website is: immediateannuities.com.
Who should consider an annuity?
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
receive a significant pension from another source, perhaps in addition to Social Security
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’s 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.
2. Survivor benefit
You can include a spousal survivor benefit. Again, no free lunch and the value of the annuity is reduced to reflect the additional longevity risk to the insurance company. If you’re married, it may be sensible to include this but you need to assess your individual circumstances, the cost difference, etc.
3. Minimum payback guarantees
You can ensure that you (really your estate) receives some minimum payback of your original purchase amount. Once again, no free lunch and if you opt for this benefit, your monthly payment is slightly reduced.
I don't see any point in this option as you're purchasing the annuity for your lifetime benefit and you should maximize its value to you. However, consumers often like this feature 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 there is no federal guarantee similar to how FDIC insurance protects bank deposits. If the insurance company were to go bankrupt, your future payments could 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. You can lessen this risk by splitting your annuity purchase between two or more insurance companies.
6. Your health
Annuities are for people who have above average life expectancies. Insurance companies understand this 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 lottery. There are better 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 being lucky enough to live a long life.