Comparing Lifetime Income Options
Longevity risk is the greatest fear of most retirees. You can now buy insurance to protect you from longevity risk: the risk of outliving you money. Just like you insure your home, car, health, etc. from the expenses of loss, insurance companies now offer annuities to protect you in retirement. What’s more, it is the best kind of insurance because already if you lose (die early) your spouse and beneficiaries can keep protected. Like all insurance, you need to shop for the policy that best suits your needs and circumstances. Unlike health and life insurance, longevity insurance is not based on your health because you’re insuring against living too long instead of dying too soon.
The coverage you get to protect your retirement years looks more like an investment than insurance. You simply place with an insurance company part or all of your retirement money and they in turn guarantee you an annual income for life, or joint life if you want to protect your spouse. The amount of the guaranteed annual income is based on the amount of money you place with them and whether or not you want single or joint coverage. Let see how this works.
Lets assume you’re age 55 and have started to think about retirement when you reach 65. You’ve been saving money during your working years and let’s assume you have $300,000 accumulated for retirement (this could be in a 401(k), 403(b) or in an account that does not qualify as a pension such as stocks, bonds, bank CD, annuities, real estate, etc.). Let’s say you want to make sure you’ll have at the minimum $50,000 per year when you retire in ten years and this amount will be guaranteed for your lifetime. How could you position this lifetime guaranteed income now that will be ready for you in ten years? First, we need to see how much you’ll be getting from other supplies. Let’s make this easy by assuming your only other source of income will be Social Security.
By going to the Social Security Administration’s web site (www.ssa.gov) and making some assumptions, you can calculate your Social Security benefits. Let say you do that and find that your Social Security benefits will be $25,803 in ten years when you plan to retire. The task at hand is to determine how much you’ll need to give the insurance company today to buy an annuity that will guarantee you the remaining $24,197 when you retire in ten years. You’ll want to shop the market for the best buy and this is usually achieved by engaging the sets of your financial advisor. Let’s say you find a fixed index-connected annuity that guarantees that your money will grow by at the minimum 7% yearly if you later turn it into an income (yes, there are annuities from top-quality insurance companies that will do this). Also assume the insurance company rewards you with a bonus of 10% of the amount that you place with them – that is, if you give them $100,000, they’ll credit you with $110,000 if you later take a lifetime income. Yes, such bonuses are obtainable if you shop.
At age 65 the annuity you chose will guarantee you a lifetime annual income equal to 5.5% of the amount in your account when you “lock in” the income at age 65. How much of your $300,000 will it take to get the guaranteed lifetime income of $24,197 you need to supplement Social Security so you will always have at the minimum $50,000 for the remainder of your life? Since you’ll need $24,197 in ten years, and we know that will be 5.5% of your annuity’s account value, we can determine the account value by dividing 24,197 by 5.5%. This amount is $439,945. But, you’ll not need this for another ten years, so we have to determine how much you’ll need to give the insurance company now. This is where the math gets complicated and why you’ll need help. If you invested $203,314 with the insurance company today and they credited you with a 10% bonus and guaranteed that your account would grow by at the minimum 7% yearly over the next ten years, you’d have the needed $439,945 when you retire ten years hence.
You have successfully insured your longevity risk by buying an insurance policy. But, what happens if you don’t get to age 65 or you die sooner than the insurance company estimated you would?
There’s good news and bad news! The bad news is that your worries about money will be over. The good news is that your spouse can continue the income for the remainder of his/her life if you chose the joint life option. If you are not married or did not choose the spousal option, your beneficiary will get the remainder of your account value. The remaining account value will be based on how much income you have taken, if any, plus the earnings credited to your annuity. The earnings are credited based on the market index to which it is connected BUT you never participate in market losses; however, you will participate in market gains as measured by the market index. Additionally, you’ll be guaranteed some minimum rate of return by the insurance company already if the market loses every year you’ve got your money in the annuity. In other words you can’t lose but you could do really well.
So, you’ve covered your longevity risk: you simply cannot outlive your guaranteed income because your insurance company must pay you until you die and Social Security is obligated to pay for the remainder of your life. Also, you will not lose your annuity money if you die too soon because your spouse, or beneficiaries, will get the remainder at your death. The best of both world! What’s more, you can start, stop and store the income if your circumstances change (you might win the lottery or get an inheritance) AND you’ll not pay income taxes on the earnings inside your annuity until you truly start withdrawing it ten years from now. What happens if you need the income in five years? You can start it after one year as long as you’re age 59½ or better, but the amount will be lower than if you wait the complete ten years. Do you have to start at the end of year ten? No, because you’re in control. You could decide to take all you money in a lump sum and reinvest it in other places (make sure your annuity is not a payout two-tier that requires you to take installment payments over five or ten years if you don’t want a lifetime income – see the article on two-tiers in this retirement blog). You’ve covered your longevity risk without giving up control of your money.
Why have insurance companies started offering these types of annuities? It’s all because of the baby boomers. As you know there were 78 million folks born between 1946 and 1964. The demographic bulge started turning 62 in 2008 and one boomer will turn 62 every 7.5 seconds for the next 18 years. And guess what is utmost on their mind? Correct, outliving their money because they do not have a lifetime pension like their parents and grandparents did. They are turning to the insurance industry to guarantee that they’ll have a lifetime income if they live too long and have demanded that they not give away their money if they die too soon. The insurance industry has responded.
Are these policies fair to the policyholders? Like all insurance policies, they offer protection against loss and in this case those who die too soon don’t get nearly as good a deal as those who live too long. But, since your number one fear is outliving your money and you’ll not be disappointed at leaving money on the table once you’ve transcended to a place where money is not important, you’ve covered your risk at a fair price. Insurance companies are doing what they do best: pooling risk across a large group and guaranteeing that they’ll pay if the worse happens. In this case, the worst is living too long for the money you’ve set aside for retirement. If you’re worried about longevity risk, call your financial advisor today and talk to him/her about this new kind of insurance. When selecting an annuity with a guaranteed lifetime income assistance, always consider the following:
- Compare carefully how much money is needed by doing exercises similar to the above. Get help from your financial advisor!
- Compare the cost of the rider: they range from 0% to 0.4% yearly.
- How often do income factors change? yearly, every 5 years, every 10 years, etc.
- Spousal continuation provisions and also is there inflation protection.
- What income “step-up” features are offered? At step-up does the income factor, related to age, also increase?
- How long can you lock-in the guaranteed growth of the income account?
What is the rating of the insurance company?