Update to Our Longevity Insurance Plan
In the early spring of 2019, I wrote two blog posts on addressing the biggest risk every person faces in retirement, longevity risk, and how to fit an income annuity into your retirement income plan to help address this risk. You can read these two posts here and here. However, due to several major life events, we did not get around to actually purchasing the annuities I spoke of in those 2019 posts. As a result of this delay, I spent more time researching into the subject of income annuities and learned a couple other things. We, subsequently, purchased different annuities from what I wrote about a year ago. So, in this post, I will discuss my updated thought process and describe the products we ended up purchasing. First, let’s briefly review the reasons for considering an income annuity.
When planning for retirement, longevity risk is by far the biggest risk everyone faces. Why? Because no one knows how long they (or their spouse) will live….so no one knows how long they need their retirement funds to last. Therefore, it is hard to know precisely whether what you have saved is enough. If you are fortunate to have a lot of resources and can afford to live off the income your portfolio generates, or you have a generous employer pension (combined with social security benefits) that covers all your basic living expenses, then longevity risk may not be an issue for you. But, for the rest of us, longevity risk is a huge issue. And it is not something you tend to focus on until you are actually in retirement.
Why Consider an Income Annuity?
To start off you may ask, “with all their fees, can’t I do better than an insurance company investing on my own?” The answer is YES and NO. It depends what you want the annuity to accomplish. Some people just buy annuities because they cannot stomach market volatility and are looking to the insurance company to shield them from the volatility and cash out the annuity contract value in the future. If increasing the size of your retirement funds is your goal, then it is likely, given insurance company fees, that you can do better investing the funds yourself.
So, in my opinion, you should NOT buy an annuity (or any insurance product) as a ‘long-term’ investment vehicle. You should only buy insurance for its “guarantees.” So, in our case, the guarantee we are looking for the insurance company to provide is lifetime income. And when it comes to providing guaranteed lifetime income, on your own, you cannot compete with an insurance company. Why is this the case?
Insurance companies have one big advantage in this area over individuals. Insurance companies are able to take advantage of, “the law of large numbers.” If you personally want to make sure your assets will last for you and your spouse’s lifetime, you need to assume the “worst case scenario” in regards to your longevity (i.e., assume much longer than average life expectancies). An insurance company does not have to make this assumption. Because of the “law of large numbers,” they do not need to know what your specific longevity will be. With 100,000 policies in force, they know, statistically, that a small group of people will die at age 65, a bigger group will die at age 80, and another smaller group at age 95. Because of these statistics they can afford to “guarantee” every annuity policy holder a higher level of income. And that is the key…. the insurance company can guarantee this. As I said, you could easily invest your money for the same or even a higher rate of return than the insurance company over a 10-12 year period, but you cannot guarantee it!
For insurance company policy holders, the people who live longer get what is called ‘Mortality Credits” from the people who die earlier. This is why insurance companies can guarantee their payouts. If anyone is interested, the best unbiased book I have read on the different kind of annuities is called “Safety First – Retirement Planning” by Wade Pfau. The Amazon link is below.
Wade Pfau is an expert on retirement income planning. Even though he does not sell annuities, Mr. Pfau has done a lot of annuity research. His research shows that most people’s retirement assets would last longer if they “annuitized” a portion of their assets. In his book Mr. Pfau estimates that, to provide oneself the same “guarantee” the insurance company provides, one would need to set aside about 20% to 25% more money than just buying an annuity from an insurance company. And another important point he makes in his book, the lower interest rates go, the bigger advantage the insurance company has because the “Mortality Credits” play an even bigger role in the payouts.
The Advantages and Disadvantages of Purchasing an Annuity
I will quickly walk through the advantages and disadvantages of purchasing an annuity and my thought process on how we reached our buy decision.
Starting with the disadvantages, the first is the obvious one that you must give up a large chunk of your money to buy the annuities. So your liquidity is instantly reduced. If you do not have enough other liquid funds, I would not recommend anyone even consider buying an income annuity. In our case our 2 annuities only totaled 15% of our financial assets. So liquidity is not an issue for us.
Another perceived drawback to income annuities is, what if we both die a couple years after the income payouts start? We will have lost money. That is true, but this viewpoint suggests you are looking at the annuity as an investment. It is not an investment, it is a “Risk-transfer” mechanism. Your goal is to transfer your longevity risk to the insurance company. If you die early, yes, the insurance company will win, but remember, you will be dead. Does it really matter? If this bothers you because you want to leave assets to your heirs, then that is a consideration in your decision on how much, or whether to purchase an annuity. Dena and I do not have any direct heirs, so this was not a concern for us.
But you and your spouse’s life expectancy should be a consideration as whether an annuity is right for you. We did not purchase the annuities to insure my life as no one in my family in recent generations has ever reached age 80. We did it to insure Dena’s life. Dena, being of Greek decent, has a lot of longevity in her family. People in her family often live into their 90s. If Dena’s family history was similar to mine, we probably would not have bought the annuities. By the way, there are annuity products out there that do have a guaranteed death benefit, but this costs money. Usually, your starting annual payout is reduced by some amount to allow for a death benefit (the death benefit is usually the return of your premium).
Another thing to consider is not necessarily a disadvantage, but it is a risk. The insurance company could go bankrupt. If this happens, there is no federal gov’t program (like FDIC) to back you up. There are state level insurance funds, which are good if it is just YOUR insurance company that goes belly-up. But if we experience some kind of “Financial Armageddon,” these state funds will be of no use. The funds cannot cover the entire insurance industry. In this case all insurance policies will be worthless. Anything is possible in today’s financial world, but, personally, I do not think the insurance industry going bankrupt is likely to happen. Why do I think this? Because of the next disadvantage below.
In my opinion, the biggest risk to buying an income annuity (which are generally fixed payouts) is inflation. So, yes, even though we bought the annuities, I am still worried about future inflation. With recent Federal Reserve actions, I do not see how we can avoid it. The Federal Reserve has made it very clear that they are going to do whatever it takes to keep the economy and the financial industry afloat. In my opinion, this will require printing trillions of currency units, and this means inflation… eventually. Right now, with all the unemployment caused by the virus pandemic, we are in a deflationary period. Many experts think this environment will last for years…. maybe decades. I do not think that, but the fact of the matter is no one knows what will happen a decade from now. So, if high inflation does happen, our annuities will have less purchasing power. However, I thought about this a lot and weighed my inflation fears against some other considerations.
Last year I did a detailed analysis of the return on our retirement funds from 2000 to 2018. Our returns over this period were not as good as the market indexes. I could have done better, but I was not willing to take the necessary risks to do so. Why am I so conservative in my investing? Because we do not have a big employer pension (along with social security) to provide an adequate foundation of lifetime income. In other words, since we live off our portfolio, we cannot afford any big investing mistakes. This fact caused me to be more conservative in our investing. That is why I started investigating annuities as a solution. With an income annuity in place to help cover our basic living expenses, we could then be more aggressive investing our remaining assets.
Because of my fear of future high inflation, I even considered just using the funds to buy more precious metals as an inflation hedge. We already have about 15% of our assets in bullion and precious metal stocks. Did I want to push our precious metal allocation up to 30% to 35%? Although I am very bullish on precious metals, this seemed like just too big a bet on this one sector.
The final straw that pushed me to buy the annuities was the Federal Reserve pushing interest rates down to zero (and possibly below zero in the future). We all know now that interest rates are unlikely to ever again rise above current levels, at least not in my lifetime. Managing money in this environment is extremely challenging. In the final analysis, I just decided the insurance company could do a better job investing in this difficult environment than I could.
What are the benefits of purchasing the annuities? Mainly that no matter how long we live, we will have a certain level of income every year. If our social security benefits and the annuities cover our basic living expenses, we do not have to worry about outliving our assets. Also, another benefit of buying an annuity versus investing in bonds or bank CDs is any interest income is tax deferred until the time you start to withdraw income from the annuity or “cash out” the annuity to receive the contract value.
There is another big non-economic benefit for buying the annuities. It makes our financial planning infinitely easier. Assuming our basic required income needs are covered in the future, I only need to manage our money with regard to the markets for the time period until that income starts. Also, in the future, because of advancing age, I may not have the mental capacity to manage our assets (of course we could always hire an investment advisor at that time). And if I am gone, my wife does not have to make any big investment decisions. The income will already be there. Then why not just buy an immediate annuity to start income today? When you see how big the premium is for an immediate annuity for the same level of income, you will understand why we chose to delay the income start date.
How Did We Decide the Total Funds to Put into the Annuity(s)?
We were
interested in having the income begin in 15 years when I am age 80 and my wife
is age 75. I calculated what our current basic required retirement expenses are
today and inflated these figures forward 15 years (assuming 3.5% inflation) and
subtracted our projected future social security benefits (assuming 1.4%
inflation) and that was the amount of annual income we wanted the annuities to
provide. Then we got several insurance quotes on the lump sum premium we needed
to create the income we needed in 15 years. Getting the insurance quotes is
where we changed course from my 2019 blog posts about which income annuity is
the best to buy. Let me briefly review what I said last year.
I discussed the three types of income annuities:
- A Variably Annuity
- An Equity-Indexed Annuity
- A Fixed-Rate Annuity
Last year I suggested that most people should not consider the first two types listed above as these products are complicated and are loaded with fees. As such, last year I did not even consider either of the first two product types above to meet our goal of increasing our lifetime income. I was set to buy a couple of the Qualified Longevity Annuity Contracts (QLACs). QLACs are a traditional IRA friendly version of the third type annuity listed above. They are much simpler products than the other two types.
However, when we finally got to talking with the annuity insurance agent, he changed our entire outlook on what was the best product for us. He told me that the “income rider” that is offered (for a fee, of course) with the Equity-Indexed Annuities (EIAs) often had higher annual income payouts than the fixed-rate annuities. At first, I did not believe him. How could a more complicated product have a higher payout? Frankly, I thought he just wanted to sell us the EIA products where his commission is higher. But I allowed him to provide us several quotes anyway. Am I glad I did, because he was right. The annual payouts from these EIA income riders were much higher than the simpler fixed-rate income annuities, on average, about 20% higher. So, using these products, we could give us higher payouts at an earlier age.
After receiving this information, we went back and reviewed our financial plan. We decided to move our annuity income start date up three years, starting at age 77 for me and at age 72 for my wife. The EIA we finally chose had an income rider annual payout that was 23% higher than the highest quote for the QLAC products available at the time. Our recent life events causing us to delay our purchase allowed us to discover this anomaly in the annuity market. When I asked the agent how this anomaly could exist, the agent told me that many of these EIAs are purchased by wealthy people more for tax deferral reasons. He estimated as many as 50% of these wealthy policy owners never activate the income rider. When the annuity owner dies, the contract value of the annuity just goes into their estate. The insurance companies know this and take this into account when determining their income rider payout rates. As a result this situation allows for higher income payouts on EIAs to the remaining policy holders.
The EIA Product
So the decision to purchase the EIA products was an easy one. As I stated earlier these type annuities are criticized as expensive, complicated products, which is true. However, if you just focus on the income rider, the products are simple. I did not even look at the “indexed” part of the product. All I cared about was buying the product that, in 12 years, would provide the highest annual lifetime payout.
Another
advantage to the EIAs is the premium is not “gone forever” as would be the case
if you just bought a standard fixed-rate income annuity. These EIAs have an
ongoing contract value that, after fees, has a small return of maybe 1%-2% per
year. So if we change our minds in 10 years before we turn on the income
stream, we can cash out the annuity and get the contract value back (of course
only after the 7-year cancellation penalty phase has passed). The disadvantage to
doing this is we will have missed out on 10 years of market returns which may
be closer to 4% to 6% annually rather than the annuity contract’s meager 1%-2% annual
return.
Also, the income rider start date is not set in concrete. There is some flexibility
built-in to these products. We can start the income earlier (at a reduced
amount, of course) if we need it. Also, if we do not need the income in year
12, we can delay the start date and the annual payout increases. It works just
like social security.
The product we finally bought has a joint payout, starting in 12 years, of
$11,000 annually for every $100,000 in premium paid today. There is no income
reduction after the first death. At first blush, this does not seem like much….
until you do the math.
In 12 years, Dena will be 72 years, she is very likely to live into her 90s. I
used age 95 or 23 years of payouts to see what it would take for me to match
this “guaranteed” payout investing the funds myself. I won’t bore you with all
the math details. But, to match the $11,000 fixed annual payout (assuming a
short-term interest rate of 1%) for 23 years, I would have to grow $100,000
today to $225,000 in 12 years. That equates to a 7% annual return. With the
current very high equity valuations, and the current zero interest rate
environment, the chances of getting a 7% annual return for 12 years on my own is
approximately ZERO. And this effective 7% return the insurance
company is providing is guaranteed.
It is important to point out that this 7%
effective return does not apply to the contract value (the amount you would
receive if you decided to cash out the annuity in a lump sum), it is only to
determine the benefit base upon which the lifetime income payout is based on
(there is a set formula in the insurance contract to calculate the income
benefit base and the withdrawal percentage). Once the annual income starts, our
funds become part of the mortality pool. The mortality credits are what allow
this high theoretical return.
To close out the discussion, I am not recommending that everyone should buy an
annuity, but I do think everyone should at least consider them when planning
your retirement income. For the majority of people who have some assets, but do
not have a big employer pension, I think an annuity could make a lot of sense.
One last very important point. If you think you might need to add more lifetime
income to your retirement plan, the cheapest way to do this is to delay
collecting your social security benefits as long as you can. Delay to age 70 if
possible. Doing this is much cheaper than buying an annuity from an insurance
company. Why? Because the social security mortality tables have not been updated
from the late 1970s so their effective payout is higher than current commercial
annuities. Plus, social security benefits have a small annual Cost Of Living
Adjustment (COLA) applied every year. Do this first before considering the
purchase of any commercial income annuity products.
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