Most People Need Longevity Insurance rather than an Immediate Annuity

Abstract

An immediate annuity is precisely the sum of two parts. One is a deferred annuity commencing at a specified date, with no death benefit before that date. The remainder, before the deferred annuity commences, is a reverse whole life insurance policy with limited premiums. That reverse policy is effectively one underwritten by the annuitant, with the insurance company as beneficiary—a policy that benefits few retirees. However, the deferred annuity (called “longevity insurance” in the literature) is a valuable component of a retirement portfolio that supplements components that focus on safety and growth.

The summary was prepared by Jennie I. Sanders, CFA, New York City.

What’s Inside?

Longevity assumptions are a critical component of financial planning. Many retirees have sufficient resources to allocate on the basis of the goals of safety, growth, and longevity. The probability of living past one’s life expectancy is relatively low, but to do so means outliving one’s resources, resulting in a high financial impact. Longevity insurance should be akin to fire insurance in that the cost to insure should be low, paying off only if the risk occurs and paying nothing if the risk does not materialize. Obtaining longevity insurance through an immediate annuity results in unnecessary costs.

How Is This Research Useful to Practitioners?

Those retiring in the next decade are increasingly concerned about outliving their savings, and practitioners and researchers have been seeking solutions to this uncertainty. Prior research—for example, Yaari (Review of Economic Studies 1965) and Ameriks, Veres, and Warshawsky (Journal of Financial Planning 2001)—has focused on how immediate annuities provide some certainty by means of a lifetime income. Dus, Maurer, and Mitchell (Financial Services Review 2005) found a benefit in having a deferred annuity that initiates if the retiree lives beyond a certain advanced age. Milevsky and Robinson (Financial Analysts Journal 2005) suggested that retirees should plan their spending similar to how insurance companies consider expected payments, mortality tables, and investment returns in achieving a high probability of adequate reserves. Scott (Financial Analysts Journal 2008) discussed the “spending improvement quotient” (Q), arguing that an immediate annuity is more economical than saving all one’s money for an expected drawdown. He suggested incorporating a deferred annuity as a more agreeable solution, which pays off at some future date only if the purchaser is still alive. In an earlier paper (Rotman International Journal of Pension Management 2011), the author found that after age 75, the risk of longevity exceeds the risk of being invested in 100% equities in terms of the relative financial impact (supporting the usefulness of annuities).

In this article, the author points out that immediate annuities remain underutilized by most retirees despite the research supporting their benefits. He makes a plea to insurance companies to consider writing longevity insurance and explores immediate annuities as the next-best solution. He indicates that an immediate annuity is essentially two products: a reverse whole life insurance policy and a deferred annuity. He argues that a reverse whole life policy benefits the insurance company far more than the immediate annuitant, who is essentially underwriting the policy on the annuitant’s own life. More retirees may see the value of a deferred annuity, which does not have the cost associated with a reverse whole life policy.

How Did the Author Conduct This Research?

To illustrate the components of an immediate annuity, the author considers a 68-year-old male purchaser, assuming longevity according to Canadian annuitant tables and a contractual fixed rate of return of 2.5% a year. The mortality table suggests an equal split between 68-year-olds dying before and after the age of 86. Payments are made by the insurance company once a year starting immediately, with a high probability of adequate reserves (ignoring spousal features).

The immediate annuity cost of providing $1 a year for life to the 68-year-old male is a lump sum of $14.78. It costs $2.53 today if the purchaser wants to forgo annual payments until age 85 and buy a longevity annuity that pays only $1 a year if the purchaser lives past 85—which implies that the reverse whole life policy (with limited premiums) costs $12.26.

A typical whole life policy requires the purchaser to make annual payments, and upon the purchaser’s death, the insurance company pays a lump sum. The first part of an immediate annuity is structured in reverse—that is, the purchaser pays the lump sum up front and the insurance company makes annual payments but only until age 84. The first part of an immediate annuity and the first part of a traditional whole life insurance policy are actuarially equivalent when adjusted for the limited premiums.

Abstractor’s Viewpoint

The author makes a plea to financial advisers, who typically do not like annuities, “to recognize the huge risk-mitigating effect of longevity insurance.” I often say that annuities meet the needs of some investors but tend to be sold to those for whom there are better alternatives. I appreciate the author’s perspective of risk pooling—the way we buy fire insurance—for risk events that have a lower probability but a higher financial impact. I recognize the value of reasonably priced longevity insurance and hope that this article leads to insurance companies’ structuring contracts to meet this need.

Editor’s note: This article was reviewed and accepted by Executive Editor Stephen J. Brown.