by David M. Cordell, Ph.D., CFP®, CLU®, CFA, and Thomas P. Langdon, J.D., LL.M., CFP®, CFA
David M. Cordell, Ph.D., CFP®, CLU®, CFA, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFP®, CFA, is professor of business law at Roger Williams University in Bristol, Rhode Island.
Financial planners recognize that insurance, as a risk management tool, is designed to transfer the risk of uncertain outcomes to an entity that can spread those risks among many insureds. From a financial perspective, transferring risk by purchasing insurance is usually more effective than other risk management tools, such as risk retention and avoidance, when the probability of a risk is small and the financial consequence of experiencing the risk is large. Financial planners and clients have long appreciated this principle and have used products such as life, health, disability, long-term care, auto, home, and liability insurance to reduce or eliminate such risks.
Live Long, But Not Too Long
Longevity risk poses challenges for planners and their clients. The nature of longevity risk and methods of dealing with it have changed over time.
Clients who retired before the mid-1970s, and a minority of individuals retiring since then, were likely covered by defined benefit (DB) pension plans that provided a monthly income for life, regardless of whether it was short or long. Individuals who did not have DB plans often used insurance products such as immediate annuities or annuity payouts as a substitute.
Clients with DB plans and traditional annuity products are not faced with a risk of running out of money, but are exposed to inflation risk, because these financial products usually do not include benefit adjustments to account for inflation. (Variable annuity payouts can address some of the inflation issue, but they involve market risk.) While the inflation risk experienced by this group is mitigated to some extent by the automatic inflation adjustments in Social Security income, the inflation risk gap remains a concern.
Over the past 30 years or so there has been a shift away from traditional DB plans toward defined contribution (DC) plans, especially cash or deferred arrangements such as 401(k) and 403(b) plans. As the products employed have changed, so have the planning risks. DC plans usually permit an individual to choose investments that have the potential to keep up with inflation, provided that those plans are properly funded and invested over the client’s working years, and that the balances are prudently spent down during retirement.
A shortcoming of DC plans, unlike DB plans and traditional fixed annuities, is that they expose individuals to market risk, which may have a dramatic impact on the amount of income the plan participant can expect to receive. This risk is particularly acute if they retire during a prolonged market downturn, as many people experienced during the Great Recession.
Because of advances in medical science and research, life expectancies have been increasing and are expected to continue to increase in the foreseeable future. A challenge arises because increased life expectancies pose additional financial risks for individuals. All else equal, the longer a person’s lifespan, the longer his or her retirement. The longer his or her retirement, the greater the risk of running out of money to fund that retirement.
Possible solutions to this challenge may involve saving more during working years, seeking higher returns, delaying retirement, and minimizing distributions from retirement accounts early in retirement to create a buffer to fund expenses if the participant lives a long life. Unfortunately, the timing of market moves, which can have a significant impact on retirement resources, is difficult to predict and control.
Consumption and Saving in the Life Cycle
Franco Modigliani’s life cycle hypothesis, which often is referred to as the theoretical basis underlying personal financial decision making, suggests that individuals are happiest when they are able to smooth their consumption over their life cycle. Under the life cycle hypothesis, saving too much and dying with a large net worth may be suboptimal, because that net worth represents forgone consumption during a lifetime. Conversely, saving too little, and not having enough to cover expenses later in life, may also have a depressing effect on an individual’s utility. Striking the appropriate balance to achieve consumption smoothing over a lifetime is a difficult task for planners and clients, especially with the uncertainty inherent in financial markets and the timing of a person’s death.
Reducing consumption and saving more during working years, or reducing consumption in early retirement to fund costs in the final stages of life, may be inconsistent with the model’s objective of maximizing a person’s utility by smoothing that consumption over a lifetime. Furthermore, retirees often receive more utility, or enjoyment, from expenditures in the earlier years of their retirement when they are healthier and more likely to be able to travel and pursue pleasurable activities. As individuals age and their health declines, many find that extensive travel and busy social calendars are more of a chore than a pleasure. Consequently, consuming more during the earlier years in retirement may be a rational choice under the life cycle model, but poses a risk of running out of money if the client lives too long.
How to Keep Pedaling on the Life Cycle
How can we hedge this risk of living too long? With longevity insurance, of course. Longevity insurance makes sure that a client will have a minimum lifetime income by providing a lifetime annuity payment that begins at an advanced age, usually 85. Guaranteeing an income stream for the later years in retirement allows the client to use more of their retirement savings earlier in their retirement when use of that money will generate more utility, without the worry of becoming penniless later in retirement. Longevity insurance also simplifies retirement planning, because it is easier to plan for a finite period—the period between retirement and the date when the longevity insurance kicks in—as opposed to stretching out retirement savings over an uncertain lifetime.
While the term “longevity insurance” may be a relatively new one in financial planning circles, the product used to hedge the risk is anything but new. Usually, a single premium deferred annuity (SPDA) is purchased before or at retirement that will pay a monthly or annual income stream when the client reaches a specified age, usually 85. The cost of the SPDA will be relatively low for three reasons: (1) the deferral period is long, typically 20 years or more, discounting considerably the lump sum needed to purchase the annuity stream; (2) average life expectancy is usually lower than the triggering age for the annuity, which allows an insurance company to spread the longevity risk among a pool of insureds, most of whom will never receive a benefit; and (3) even those insureds who reach the specified age for benefits to begin are not likely to receive those benefits for very long because of their life expectancies.
From the insured’s standpoint, this form of risk transfer to an insurance company is theoretically sound. That is, the probability of the risky occurrence is relatively small because most of the population will not reach age 85, and the financial consequences of living beyond that age can be very significant.
Refining the Plan
Planning issues that emerge with the use of longevity insurance include the impact of inflation on the annuity payments and the possibility that the insured will not receive benefits from the contract if he or she dies before the annuity payments are triggered. Many companies offering annuities for this purpose also offer inflation protection or guaranteed survivor benefits for an additional cost.
Purchasing longevity insurance in the correct wrapper may be important if income tax planning is a concern. Income from annuities is subject to ordinary income tax rates. Furthermore, the Patient Protection and Affordable Care Act of 2010 imposed a 3.8 percent Medicare surtax on distribution from annuity contracts for high income individuals. Longevity insurance purchased directly could subject a taxpayer, at the highest marginal income tax rates, to income tax at 43.4 percent.
Instead of purchasing the contract directly, a taxpayer could purchase it inside his or her IRA or Roth IRA. Distributions from traditional IRAs are not subject to the 3.8 percent Medicare surtax, immediately eliminating that tax if the annuity is held inside the IRA. One potential problem, however, involves required minimum distributions (RMDs) from the IRA once the participant reaches age 70½. Careful planning is required to make sure the RMDs can be made before and after the annuity starts to provide an income. In March 2012, the IRS proposed regulations that, if adopted, would give more flexibility to taxpayers by easing the RMD requirements for IRAs holding longevity insurance annuities if certain conditions are met (proposed REG. 115809-11).
Placing the longevity insurance annuity contract inside a Roth IRA provides a triple benefit: (1) distributions from a Roth are not subject to income tax; (2) distributions are not subject to the 3.8 percent Medicare surtax; and (3) distributions from Roth IRAs are not subject to the minimum distribution rules.
A Great Tool for the Right Client
A particularly enticing aspect of longevity insurance is the fact that, unlike life insurance, it is not underwritten, so planners can use adverse selection to their clients’ advantage. That is, a client with long-lived ancestors and a healthy lifestyle is more likely to benefit from longevity insurance than a client who lacks those qualities.
Longevity insurance provides some flexibility for those approaching retirement and may permit them to enjoy the early years of their retirement without having to worry about running out of money. In an age of increasing life expectancy and, so it seems, increasing market and inflation risk, longevity insurance may be just the prescription for a worry-free retirement.