The U.S. Treasury recently proposed a rule change that would make it easier to purchase longevity insurance products with 401(k) and IRA money without running afoul of Required Minimum Distribution Rules. The change should cause an increase in interest, though the proposed relief applies only to 25% of the account or $100,000, whichever is less.
In its most basic form, longevity insurance has many of the same characteristics as an immediate annuity. You send the insurance company, which you hope is sound, a check and get a lifetime income payment in return. You lose access to your funds and there is no inheritance unless you agree to smaller payments. Payments however, start later, usually between 80 and 85.
These products may be utilized more often than immediate annuities primarily because they require a lot less capital to assure a later-in-life income stream. Because the insurance company pays nothing for 20 years, it can put those funds in higher-yielding investments. According to one article, a 65-year-old man buying $50,000 in longevity insurance would get $28,600 annually for his life beginning at age 85. According to an estimator at Income Solutions, it would take about $424,000 to purchase a traditional annuity that would begin payments of $28,600 per year immediately.
From a purely mathematical standpoint the return can be very good for people with long lifespans but in a different form. Like immediate annuities, unless one lives long enough, the effect on net worth is negative. It will take almost 15 years (age 80) before the immediate annuity has returned the full $424,000. With immediate annuities, the longer one lives the closer the actual result approaches the initial payout rate.
With longevity insurance, if our buyer dies prior to age 85, his family gets nothing in return. If he makes it to 85, he gets the contractual payout for life. In that case, this is the same as a life-only immediate annuity paying $28,600 year. At current rates, 85 year olds can buy $28,600 for about $191,000. It looks like for $50,000, he gets something worth $191,000, but the income payments are only worth that to him at that moment if he is alive. He is not guaranteed to get that and can't get his hands on that amount, ever.
Sadly, I have seen these pitched as though the buyer gets a great return -- in this case 6.9% -- what it took for $50,000 to grow to $191,000 in 20 years. That is not an actual result. If he dies, after just one payment, all he got from his $50,000 would be $28,600. After two payments he is only $7,200 to the positive ($28,600 x 2 less $50,000) -- after 22 years.
However, the net result goes up considerably with each payment received. By the time the owner receives 10 payments, after 30 years at age 95, the return on that original $50,000 is near 7%. According to the Social Security Administration's 2007 mortality tables, life expectancy for a 65-year-old man is a bit more than age 82 and the odds of a 65-year-old man living to age 95 is roughly only 8%.
If one truly lives much longer than the mortality tables suggest, longevity insurance could provide a tremendous result, but if one's lifespan is not exceptional it will be a hit against the family' net worth. Offsetting that to some degree is the significantly lower amount of capital required to fund a later-in-life income stream.
"Yeah, immediate annuities don't pay a ton, but when interest rates rise they will be hot."
Maybe. I think this point has more validity with younger purchasers.
The way annuities are priced, interest rates affect payouts more at younger ages than older ages. For older buyers, mortality factors dominate. The exact numbers vary from chart to chart, but the general pattern persists. Increase interest rates for a 65-year-old male from 1% to 4%, and the cost of the annuity will drop about 26%. The same jump in interest rates for an 85 year old decreases the cost by only about 13%.
In addition, history shows few people bought immediate annuities even when they paid more. Interest rates won't change just for insurance companies. Other lower-risk alternatives to annuities will probably look more attractive, too. The 8%-plus payout rates a 65-year-old male could get in the recent past looks good now, but they didn't draw buyers when the market interest rates supported such a payout. The negatives I outlined exist regardless of the level of market interest rates.
So yeah, the primary purpose of an immediate annuity is to provide an income stream for as long as a person lives, and it does this very well. For some it will be a nice complement to their other positions. But, for most, these contracts' lack of flexibility, lack of access, and guarantee to make an insurance company an heir will continue to make them an unattractive proposition for most potential buyers.
Dan Moisand, CFP, has been featured as one of the America's top independent financial advisors by most leading financial advisor publications. He has spoken to advisor groups on five continents on topics such as managing investments and navigating tax complexities for retirees, retirement readiness, and most topics relating to the development of the financial planning profession. He practices in Melbourne, Fla. You can reach him at [email protected].