Longevity insurance: Annuities for the long haul

There’s a strong tendency toward underestimating life expectancy.

When asked to estimate how long the average person their age and sex can expect to live, approximately 60% of retirees and pre-retirees provided a response that was below the average, according to “The 2011 Risks and Process of Retirement Survey,” prepared by the Society of Actuaries.

Approximately 54% of the individuals who participated in the survey said they were very or somewhat concerned about depleting their savings. As it’s becoming more common for people to live into their 80s and 90s, and even to 100, this concern isn’t going away soon.

Given these facts, combined with the uncertainty of the sustainability of a traditional investment portfolio as a source of retirement income, a product that provides guaranteed lifetime income beginning in the later stage of life should have a lot of appeal to individuals who are concerned about outliving their financial resources.

Enter longevity insurance

There’s a lot of confusion among advisers and consumers alike when it comes to longevity insurance. Much of the confusion stems from the fact that, unlike traditional insurance products like homeowner’s insurance or life insurance that insure a single risk that could occur the day after you pay your initial premium, the potential benefits available from longevity insurance, if they’re realized, won’t be seen for many years.

Longevity insurance isn’t a product in and of itself. It is instead the application of a type of life insurance industry product with a long and established history — fixed-income annuities. This type of annuity is used to provide either immediate or deferred income payable for a fixed term, e.g., 10 years, or lifetime, depending upon one’s needs. In the case of longevity insurance, deferred lifetime income is the appropriate solution, with income typically, but not always, beginning at age 80 or later.

Traditional longevity insurance

Up until now, the vehicle that’s been used as the traditional funding mechanism for longevity insurance has been the deferred income annuity, or “DIA.” By definition, the start date of DIA payments is contractually defined and is deferred for at least 13 months. The longer the income start date is deferred, the lower the premium, or investment, required to provide a specified amount of income.

Although DIA’s can be purchased for a specified term, e.g., 10 years, when used as longevity insurance, the payout often starts in one’s 80s and is for life. In addition to our current low-interest rate environment, there are two other drawbacks to using DIA’s as a longevity insurance solution: (1) there are currently only a handful of life insurance companies offering them, and (2) limited, or perhaps no benefits may be realized in the event of premature death.

When viewed in the proper perspective, the second drawback is simply a function of the nature of insurance. As a means of transferring risk, some individuals will benefit more than others. By definition, those who live the longest will receive the greatest amount of income. Having said this, the risk of not receiving any benefits can be mitigated by purchasing a DIA that will return your investment in the event of death prior to the commencement of lifetime income; however, this will often increase the required premium.

Alternative solution

Although it hasn’t been marketed as such, fixed-index annuities (“FIA’s”) with income riders, or guaranteed lifetime withdrawal benefits (“GLWB’s”) are an appropriate, and oftentimes preferred,longevity insurance solution. Like DIA’s, FIA’s with income riders furnish the opportunity for deferred income.

FIA’s with income riders offer several advantages over DIA’s as a longevity insurance strategy. Unlike DIA’s where you’re generally locked into a contractual income start date when you purchase the product, FIA’s have greater flexibility. Income withdrawals can generally begin any time at least one year after the initial investment, or premium, is paid. The longer the start date is deferred, the greater the amount of lifetime income.

A second advantage of FIA’s vs. DIA’s is their accumulation value. Unlike DIA’s which are a pure income play with no value associated with them other than the present value of their future income stream, FIA’s have a contractually defined investment value. This value is generally increased by initial and subsequent investments as permitted, applicable premium bonuses, and earnings, and is decreased by withdrawals and income rider and surrender charges. To the extent that there’s accumulation value remaining upon the death of the owners, it’s payable to the contract’s beneficiaries.

When you compare income from a DIA to a FIA with an income rider with comparable income start dates, it’s not unusual to find FIA’s that produce similar or greater annual income payouts. In such cases, the presence of an accumulation value/death benefit combined with a flexible starting income withdrawal date usually favors a FIA as the preferred longevity insurance solution.

Depending upon one’s needs and marketplace availability, it may make sense to use a combination of DIA’s and FIA’s with income riders, and potentially multiple products within each category, to meet deferred lifetime income, or longevity insurance, needs. As with all things of this nature, a thorough analysis should be prepared by a professional retirement income planner to determine the solution that best meets your needs.

AUTHOR DISCLOSURE: Robert Klein is licensed as a Resident Insurance Producer in California (License #0708321).

By Robert Klein

Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.