Michael Kitces published an article for Bank Investment Consultant explaining how “This tool can take the mystery out of retirement planning.” The took he is referring to is an annuity product, in particular a longevity annuity. The uncertainty of our life span is one of the hardest parts of retirement planning. We simply do not know how long we are going to live, but we have to plan financially for a long life just in case we have one. No one wants to run out of money during retirement and on the flip side, we also don’t want to keep all of our money set aside for later in life and then never get to enjoy it. Annuities are a welcome alternative to drawing down from a diversified portfolio. While you can make adjustments to your portfolio as time goes on, you are never actually guaranteed that your money will last. Although annuities make a lot of sense in retirement planning, they are not used all that often. Economists call this the annuity puzzle. Using a single premium immediate annuity or a longevity annuity in your retirement planning can be a great alternative to hoping to live off of the returns of your fixed income portfolio.
Longevity risk is one of the biggest retirement concerns. You can spend more and invest more aggressively if you are going to live 10 years in retirement versus 30 years. But you really have no idea how long you will live, an issue that only annuities can eliminate. Use a portion of your assets to buy an immediate or longevity annuity that will guarantee to pay you income for as long as you live. Some people avoid annuities because they want to keep their money more liquid. This is why we recommend using only a portion of your savings to buy annuity income. Longevity annuities don’t start paying your income until later in the future. This can make them more “affordable” than immediate annuity products. Annuities allow you to transfer your longevity risk to an insurance company. They can absorb that risk because they are insuring a large group and some will die younger than others. This allows you to take advantage of mortality credits and receive more income than you would by investing on your own.
While immediate annuities are right in some situations, this article lists an excellent example of how a longevity annuity affordably eliminates longevity risk. Purchasing a longevity annuity that starts paying you income in 20 years gives you the freedom to know that you only have to finance 20 years with your other assets. You can invest freely with the knowledge of the exact time frame that you will have to make your money last. After the initial 20 years is up, your longevity annuity will pay your income until you die. One option for creating income for that first 20 years would be to ladder TIPS bonds for yearly income. The detailed example shows, however, that your income and remaining money are similar when using a TIPS and longevity annuity strategy versus just buying an immediate annuity right at retirement. The major difference is with the liquidity of your money for that first 20 years.
When you are trying to decide whether a longevity annuity is right for your retirement planning, it really depends on the other alternatives you are considering. Right now, an equity centered portfolio appears to have better returns than using a longevity annuity, although it doesn’t have the guarantees. You have to decide which benefit is more important to you. Longevity annuities are much better than using fixed income assets throughout your portfolio though. Bond portfolios give you back principal and interest payments, but longevity annuities include mortality credits along with those other things. You eliminate longevity risk as well. It’s possible that longevity annuity rates will rise in the future and make them more desirable when compared with using equities. The only way to eliminate longevity risk and unknown time horizons in retirement planning is by purchasing a longevity annuity.
Written by Rachel Summit