Executive Summary
One of the hardest risks to manage in retirement is the uncertainty of longevity – how long the retiree will live, and therefore how long of a retirement time horizon needs to be planned for. Planning for too short of a retirement time horizon can lead to asset depletion if the retiree actually lives. Planning for too long leads the retiree to unnecessarily constrain retirement spending for a future that never occurs.
While one popular approach to managing the issue is simply to invest in a diversified portfolio, spend conservatively, and make adjustments in the future as necessary, an alternative is to actually buy “longevity insurance” in the form of a lifetime annuity. Historically, this could be done by purchasing a single premium immediate annuity at retirement, except in practice retirees rarely ever want to lock up so much of their capital - in fact, retirees annuitize so rarely that economists have dubbed it an "annuity puzzle".
A potential alternative, though, is to use a longevity annuity. This form of single premium deferred annuity still provides payments for life, but with payouts from the longevity annuity company not beginning until the distant future (e.g., at age 85). The upshot to this approach is that it significantly reduces how much capital must be committed to securing the longevity insurance guarantee, even as the deferred starting date can also delay required minimum distribution (RMD) obligations if purchased as a "qualified longevity annuity contract" (QLAC) inside of a retirement account.
And despite today’s low interest rates, a current longevity annuity quote reveals that it can already be an appealing competitor to the expected returns of a fixed income portfolio. In fact, if longevity insurance rates rise just a bit more, they may even become competitive with long-term equity returns, thanks to the benefit of mortality credits. Which means eventually, an allocation to a “longevity annuity bucket” may become a standard in retirement income planning… at least, as long as life expectancies don’t increase so much in the coming years that the longevity annuity rates just end out going down!
Retirement And Longevity - The Unknown Time Horizon Problem
One of the greatest challenges to crafting a retirement portfolio and retirement spending strategy is that both are highly dependent on a completely unknown variable: the time horizon for retirement itself. After all, those who will live in retirement for “only” 10 years can spend far more than those who may be retired for 30+ years, and the latter also may need a larger allocation to growth investments to keep up with the pernicious impact of inflation compounded for decades. Yet without knowing the time horizon, it’s impossible to know whether spending should be higher or lower, and whether the portfolio can be more conservatively invested or “needs” to be somewhat more aggressive.
In the extreme, one approach to handling the situation is simply to put most or all of one’s retirement funds into an immediate annuity, which eliminates the time horizon problem for the retiree by receiving guaranteed payments “for life” from the insurance company. Technically, this simply shifts the unknown time horizon from the individual to the insurance company, but the good news is that thanks to the law of large numbers the insurance company can predict the time horizon for a large group of people with a relatively high degree of accuracy – far more than any one retiree can for just their individual sample size of one.
Yet the caveat to the immediate annuity solution is that, despite its simple elegance, virtually no retirees actually annuitize a significant portion (much less all) of their retirement wealth. One research study found that immediate annuities would leave most retirees ill prepared for a health care “shock” event (except, ironically, those who have so much money they wouldn’t need the annuity anyway). Some theorize that in general retirees just have a stronger preference for liquidity than what an immediate annuity offers. Others suggest it’s simply because the payouts are too low.
Yet whatever the reason, this “annuity puzzle” persists, and retirees who “could” solve the time horizon problem by annuitizing most of their wealth continue not to do so.
What Is Longevity Insurance And How Does It Manage The Retirement Time Horizon Problem
Longevity insurance, also known as a longevity annuity or an advanced life deferred annuity, is a form of deferred annuity contract designed to provide “payments for life” but with payments that don’t begin until the distant future. Thus, for instance, while a single premium immediate annuity would provide lifetime income beginning now (e.g., purchased at age 65 with payments beginning at 65), the longevity annuity would take the same lump sum up front (at 65) but payments might not begin until the distant future (e.g., age 85).
The benefit of using longevity insurance as part of a retirement portfolio is that it helps to solve the unknown time horizon problem. For instance, imagine a 65-year-old couple that purchases a longevity annuity that will begin to make significant payments at age 85 to cover all their (inflation-adjusted) needs later in life. This couple’s retirement investment puzzle is now greatly simplified: they just need to cover the fixed time horizon of the next 20 years, because the longevity annuity will take care of “everything thereafter” if they are still alive.
In other words, the couple has just turned one of the biggest retirement challenges – investing for an unknown retirement time horizon due to the uncertainty of mortality/longevity – into a much more manageable problem over a known time horizon of investing from the start of retirement until the annuity starting date when the longevity annuity payments kick in. From that point forward, the longevity annuity covers “everything”, regardless of how long the retiree lives. In essence, the longevity annuity is providing longevity insurance against the retirement portfolio and creates an “end point” (when the longevity annuity payments begin) that most retirement plans don’t have when the retiree otherwise doesn’t know how long he/she will live.
Thus, continuing the prior example, let’s assume this 65-year-old couple has $1,000,000, and wants to spend $30,000/year from their portfolio (adjusted for inflation) for the rest of their lives, to supplement available Social Security income. At 3% inflation, $30,000/year will be $54,183/year in 20 years (at their age 85). Based on current pricing (for inflation-adjusted payments, with a joint survivorship payout that continues as long as either are alive, and a cash refund guarantee), this couple can buy a longevity annuity for their future $54,183/year (which is $4,515.28/month) beginning at age 85 for a longevity annuity cost of about $249,000. This purchase will leave the remaining $751,000 of the portfolio available to cover just the next 20 years.
Now, instead of trying to invest $1,000,000 for a $30,000/year inflation-adjusted income for an unknown time horizon, the couple can invest $751,000 for a $30,000/year inflation-adjusted income for exactly 20 years, secure in knowing that all payments beyond that point will be covered by the longevity annuity and backed by the longevity insurance company.
Using A TIPS Bond Ladder To Secure 20 Years Of Inflation-Adjusted Retirement Income
Once a longevity insurance ensures that the later years are covered, the initial 20-year time period of a retirement portfolio could then be covered with a diversified portfolio, or simply by something like a ladder of TIPS bonds, providing the exact amount of inflation-adjusted income for each of the 20 years, and entirely securing the couple’s lifetime income! In fact, it would only take about $554,000 to buy a ladder of TIPS to cover the payments for the next 20 years, leaving almost $197,000 left over as well! And whether the couple lives to age 85, 95, or 105, they will have inflation-adjusted income for life as the longevity annuity payouts occur in the later years.
Of course, the reality is that this 65-year-old couple could have simply purchased a single premium immediate annuity with inflation-adjusting payments to cover their lifetime guaranteed income goal as well, simply starting at age 65 when they retired. However, the purchase of an immediate annuity (again inflation-adjusting, joint survivorship payments, with a cash refund guarantee) would require about $772,000 of their capital, leaving only $228,000 over for ‘emergencies’ and contingencies – which is similar to the $197,000 left over from the longevity annuity scenario. Except remember that the $554,000 in TIPS bonds would still be a liquid portfolio that could be adjusted if desired!
While it may be appealing to use the longevity annuity in this context, as it obtains similar longevity guarantees but at a lower upfront cost, it’s notable that the total “cost” in required dollars is similar. This shouldn’t be surprising, as whether buying a TIPS portfolio plus an inflation-adjusted longevity annuity, or an inflation-adjusted immediate annuity to cover the same time period, both the investor and the insurance company are ultimately investing in the same capital markets for the same time horizon and the same available bond yields! The only difference is the liquidity of the capital in the meantime, which arguably would be more appealing in the longevity annuity scenario over the single premium immediate annuity (similar income, similar costs, and more liquidity in the meantime).
Longevity Annuity Rates Versus Long-Term Equity Returns
In a world where the longevity insurance covers retirement spending for those who live past an advanced age like 85, the portfolio design process is greatly simplified; it just needs to cover the finite time period from retirement (e.g., age 65) until the payments begin from the longevity annuity. This 20-year time horizon would likely be covered by a rather bond-heavy portfolio (given how much spending must be supported in the near- and intermediate-term years) and as noted earlier might even be funded outright with a 20-year (TIPS) bond ladder.
In turn, this means that in practice, the longevity annuity is likely to replace primarily equities in the portfolio, which are what would have been otherwise invested for retirement spending that by definition wouldn’t have to begin for at least 20 years. After all, the reality is that any investor in a simple diversified portfolio could always choose to segment their portfolio into two buckets: one to cover the next 20 years, and one to cover all retirement expenses beyond that point (i.e., age 85 and beyond). At that point, it’s just a question of whether the later-years’ bucket is filled with income from equities, or funded with the backing of a longevity insurance company.
Accordingly, this means an assessment of whether a longevity annuity fits in a retirement portfolios is really a matter of comparing the long-term economic value – i.e., the internal rate of return – that can be produced by equities, versus ongoing cash flows from a longevity annuity.
In other words, based on the longevity annuity quote earlier – with a payment for a married couple of $$4,515.28/month – will pay out the equivalent of a 5.3% internal rate of return if at least one member of the couple lives to age 100 (and assuming 3% inflation). Which means to produce equal-or-better cash flows from equities, a long-term equity portfolio must produce a comparable long-term rate of return.
Yet when compared to actual historical returns, suddenly the longevity annuity begins to look somewhat less appealing. The graphic below shows the rolling 20-year and 35-year total return for equities over the past nearly-150 years (based on available data from Shiller). And as the data reveals, it’s only happened a few times in history that equities failed to generate the required 5.3% “hurdle rate” to beat a longevity annuity, even over “just” the 20-year time period from age 65 to 85… and equities have always generated enough return over a 35-year time period (from age 65 to 100) to beat the cash-on-cash payouts from a longevity annuity and still have money left over.
In fact, the graphic below shows the results of simply investing $100,000 in an all-stock portfolio and taking the exact same withdrawals that a level longevity annuity would have paid. At current rates, a $100,000 deposit for a 65-year-old couple would pay $2,255.02/month starting at age 85 (with a cash refund guarantee if the couple dies before all principal has been returned). Yet as the results reveal, even in the worst case scenario the equity portfolio doesn’t run out of money by making the exact same payments as the longevity annuity. In fact, the worst scenario still has almost all the starting principal left over! On the other hand, in nearly half the scenarios, the retiree with equities covers all the payments a longevity annuity would have provided, and has more than 10X their starting $100,000 principal left over as well (i.e., starting principal grows over $1,000,000 in value, on top of funding all longevity annuity withdrawals!). In some cases, starting principal is multiplied by 20X, 30X, or even 50X!
What this dichotomy highlights is that, for most retirement scenarios, the real challenge point is not necessarily getting sufficient returns to fund retirement with growth in the later years, after the first 20 have already passed (e.g., with a longevity annuity, or just with equity investing); it’s generating enough of a return to fund the first half of retirement without using up all the available assets (given the lower returns entailed in investing for the shorter portion of the time frame!).
In other words, to the extent that cash flows can be addressed sufficiently to cover the first half of retirement, the time horizon is long enough that an equity-centric portfolio can fund the “long-term” spending needed in later retirement (for the subset of retirees who even live long enough to need it) without using a longevity annuity. Sequence of return risk isn't an issue for a retiree who's already committed to not touch this portion of funds for 20 years (whether in a longevity annuity or an equity portfolio).
In point of fact, this is also an indicator of why recent research on a “rising equity glidepath” in retirement may be helpful as well; in the few scenarios where equity returns are relatively poor early on (close to the hurdle rate), spending disproportionately from fixed income in the early years and allowing equities to grow – which indirectly shifts the overall portfolio allocation to an increasing equity exposure – actually helps to facilitate long-term success by allowing equities the time to generate the needed returns for later retirement!
Payouts At Current Longevity Insurance Rates Versus A Fixed Income (Bond Or CD) Portfolio
Notwithstanding the implied ‘dominance’ of equities over a longevity annuity in the long run – at least at today’s payout rates – it’s notable that for those who are going to invest purely in fixed income for retirement (e.g., bonds and CDs but not equities), using longevity insurance is still far superior to a fixed income portfolio in the long run.
The primary reason for this is that while a bond portfolio can provide principal and interest payments over time, a longevity annuity provides principal, interest, and mortality credits attributable to all those who didn’t survive as long. In other words, not only does longevity insurance eliminate the time horizon problem for those who live a very long time, but it gives “outsized” payments to those who are the survivors (who receive allocates of principal and interest from the share of those who died earlier).
Accordingly, the chart below shows the real (inflation-adjusted) internal rate of return for a longevity annuity from a high-quality longevity insurance company (which in turn is backed by a state annuity guaranty fund) assuming 3% inflation, versus buying the real yield of a government TIPS bond of varying term. In the early years, the government bond is not surprisingly the superior strategy – after all, it doesn’t “pay” to buy a longevity annuity and not live long enough to receive many (or any) of the payments. However in the long run, it’s ultimately the longevity annuity that provides a far superior rate of return.
It’s also worth noting again that this distinction isn’t because the longevity annuity company is a “super investor”, but simply because the company can buy the same bonds as the investor and then stacks mortality credits on top. In addition, from the perspective of time horizon, the longevity annuity is even “more” superior here, because a 30-year laddered bond portfolio runs out in the 31st year, while a longevity annuity just continues to pay, even for those few who happen to live far beyond. In other words, in the long run the longevity annuity both provides a superior internal rate of return for those who live a long time, and gets better for those who continue to keep living – as opposed to a fixed income portfolio, that can run out altogether for those who continue to keep living!
The Benefit Of Longevity Insurance Depends On What It’s Compared To
Ultimately, what all of this really means is that the benefit or “value” of buying longevity insurance in the form of a longevity annuity depends heavily on what it is compared to. Relative to an equity portfolio, the longevity annuity is arguably still inferior, at least given today’s payout rates. In fact, equities so dominate the value of a longevity annuity, that it doesn’t even pay to use a qualified longevity annuity contract (QLAC) instead of an IRA to defer required minimum distribution (RMD) obligations, if it means giving up access to equity returns.
On the other hand, relative to fixed income returns, it is the longevity annuity that dominates, both in terms of returns and the management of the unknown retirement time horizon – and in such scenarios, the potential of a QLAC to defer RMD obligations is just an additional bonus. In other words, if a longevity annuity will be used to replace a fixed income investment and is otherwise appealing, it’s even better to do so with available dollars in a retirement account as a QLAC.
An additional benefit of using this form of single premium deferred annuity is that it provides guaranteed payments for life – similar to a single premium immediate annuity – but the fact that longevity annuity payments only occur for a limited (later) number of means the retiree can commit far less in portfolio assets to get the guarantee. This doesn’t necessarily make retirement “less expensive” in terms of the required assets to support it, but does allow the retirement portfolio to remain more liquid even while securing a longevity insurance guarantee.
In the coming years, though, the real question is whether or how longevity annuity rates will rise (or not) as the Federal Reserve raises interest rates. While interest rate increases in general should boost payout rates, the real impact will be driven by interest rate changes at the long end of the yield curve, not necessarily what the Fed does with short-term rates. And offsetting any benefits of interest rate increases are the “risk” that continued medical advances improve life expectancy so far that longevity insurance rates must actually be decreased instead (to account for longer retirement time horizons of extended life expectancy).
Nonetheless, the possibility remains that in the future, longevity annuity rates may eventually become competitive with or even dominate equities – thanks to the boost of mortality credits – in the same manner that the longevity annuity can already dominate a purely fixed income portfolio for generating retirement income. And at a minimum, the longevity annuity is still the only solution that can take the risk of uncertain longevity and an unknown time horizon off the table altogether. At least, as long as the longevity insurance companies themselves are effective at managing the risk!
So what do you think? Do you incorporate single premium immediate annuities into your retirement plans now? Would you consider using a single premium deferred annuity as a way to provide longevity insurance for a retirement portfolio at a lower cost? How high would longevity annuity rates have to rise for this to be a compelling solution for your clients?
