Retirees are becoming a larger part of the population while their capacity to fund retirement comfortably has been declining. The population 65 and older, which now numbers about 48 million, is expected to rise to about 73 million in 2030. Meanwhile, the portion of retirees with employer-defined benefit plans that funds them until they die has been declining and is now less than one out of every 10. Most retirees must fund their own retirement, and face the risk that their funds will turn out to be inadequate and they will be forced to spend the last years of their lives living on social security alone.
Financial planners who counsel retirees confront their fear of running out of money all the time, and have developed some rules of thumb for dealing with it. One is the 4% rule, which says that the retiree whose assets are invested in well-diversified and low-expense equity funds can safely draw 4% of the starting value of the fund each year, plus an increment equal to the rise in the cost of living in the preceding year. The trouble with this rule is that it promises to work about 98% of the time but not all of the time. Nobody wants to live with a 2% probability of a financial catastrophe - we purchase insurance on our homes to avoid hazards that have a probability of occurrence that is less than 2%.
What retirees need is a type of insurance policy in which those who die earlier help fund payments to those who die later. In fact, this type of policy now exists. It is called a "longevity annuity," but that is a misnomer because it is actually an insurance policy. It insures against the risk of impoverishment from living too long. The best way to understand how a longevity annuity works is to compare it to a standard annuity.
In both cases, the consumer pays a large one-time fee at the outset, and receives monthly payments for the rest of their life. On the most common type of standard annuity, the payments begin immediately. On other versions, the payments are deferred for some period but the consumer receives death benefits if they die during that period. On a longevity annuity, in contrast, payments are deferred until some specified age, as late as 85, and if the consumer dies before reaching that age, they receive nothing. In effect, the premiums paid by those who die before the deferral period are paid to those still living, which makes it possible to provide those still living with larger monthly payments. This transfer is what makes the longevity annuity an insurance policy.
Here is an example. The retiree of 65 has financial assets of $600,000 that will earn an estimated 5% over his remaining life. If he draws $3,000 a month, his assets will be fully depleted in 431 months, when he will be 100. That leaves a small probability that he will still be alive at that point, and destitute. That small probability can be a major source of anxiety.
To avoid having to live with the fear of living too long, he uses $200,000 of the $600,000 to purchase a longevity annuity with payments of $3,000 a month beginning in month 121. While his remaining $400,000 of invested assets will now be depleted in month 196, at that time he will already be collecting the $3,000 under the annuity, which will continue until he dies. The spread between the date when the annuity begins and the estimated depletion date of the assets is the retiree's safety margin during which he collects from both sources.
The numbers cited in the preceding paragraph are drawn from a spreadsheet-based model of the longevity annuity developed by my colleague Allan Redstone, and don't necessarily correspond to the amounts that would be offered by any of the insurers who offer them. However, a quick comparison with the amounts reported by www.immediateannuities.com indicates that the spreadsheet estimate is in the ballpark. The market for longevity annuities will be discussed in a future article.
The longevity annuity has much in common with the HECM reverse mortgage in that both are designed to ease the financial burdens faced by retirees. How they might be used to complement each other will be discussed next week.