(Originally posted July 24, 2007)
The uncertainty of one’s age at death, results in the biggest fears of retired persons, i.e. that they’ll run out of assets before they die. The risk of living too long constrains spending during “active” retirement years. Actually living too long reduces or eliminates the estate. A Longevity Insurance product, a modified form of annuity, could offer a low cost solution. A single premium of $x at age 65 results in an annual insurance payment of approximately $x/year starting at age 85 until death.
In an oversimplified form, for each $1 of premium paid at age 65 the insured will receive approximately $1/yr (hopefully even inflation adjusted) from age 85 until death. There are no payments to be made if insured dies before age 85 and there are no minimum number of years for which payment is guaranteed. This is treated the same as auto or property insurance, whereby payment is only made if a “loss” occurs (in this case, if insured lives beyond age 85).
A detailed actuarial calculation is required but, the combination of tax-free compounding over 20 years ($1 becomes $2 real at 3.5% real return per year) and the mortality benefits accruing to those surviving to age 85 (only about 33% of 65 year olds make it to 85) results in about $6 (real) being available to annuitize at age 85.
The mortality credit at age 85 of about 800bp added to a nominal return of 700bp at that time results in 1500bp return on each $6 annuitized. Therefore the original $1 investment yields about $0.90/yr return starting at age 85.
An individual who has $1,000,000 assets allocated for retirement and plans to take $45,000 (4.5%) inflation adjusted per year, could secure a continuing income of $45,000/yr from age 85 until death by one-time $50,000 (5% of assets) premium at age 65 to purchase the Longevity Insurance. The 4.5% just happens to be close to the often quoted 4-4.5% max withdrawal rate rule of thumb, for a portfolio of 60% stocks and 40% bonds, to minimize (not guarantee) the chance of exhausting the assets in 30 years.
Clearly some allowance must be made for cost of asset management and trustee services, but there are low cost suppliers in the 0.5%/yr range. There is also the possibility to have the plan set up so that the insured shares the investment and mortality risks/rewards with the asset manager/trustee. The driving forces behind achieving such a beneficial outcome are the mortality benefits juicing up the tax-free compounding and the no-frills annuity.
5% of one’s assets intended to support retirement income, seems like a small price to pay to permit a more worry free retirement, potentially increased spend rate and a larger estate. If one dies relatively young, then running out of assets is not an issue and the estate may also likely be larger. Thus, this is an ideal retiree insurance product. (A hint of related products, but none like the above, started emerging in the past year-see WSJ, Setting Up Your Own Pension, March 11, 2006)
I approached York University Professor Milevsky originally in 2003 asking his opinion about a longevity insurance product based on pure deferred annuities (no money back except if you live to specified age). He was doing research in the area of annuities and their role in retirement planning. He felt that there a need for such a product and was looking at something related to this. One of his early interesting papers on longevity insurance actually envisaged purchasing such a product at quite young age (during working years) and then get the benefit starting at age 85. Time will tell if one could convince too many 35 year olds, who are paying for mortgages and children’s education to spend money on such insurance, but he wrote a very interesting paper on this“Real longevity insurance with a deductible: Introduction to advanced-life delayed annuities”
He also had a very interesting short article about five grandmothers to explain how mortality credits bring the real value to annuities. The mortality credits add a kicker to returns of 35, 83, 237, 725 and 2004, at ages of 55,65,75,85 and 95 respectively. So annuitization starts getting interesting around age 75 and really interesting near age 85. You can read more in “Grandma’s longevity insurance” Finally early this year there were reports that longevity insurance product was finally becoming available in WSJ’s“If you outlive your savings” and more recently in Business Week’s“More dollars later in life”