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To Insure Longevity Risk Or Not: That Is The Question

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The goal of retirement income planning is to convert the client’s nest egg into a stream of inflation-adjusted income that will last the client’s lifetime. This involves 3 major unknowns:

o Investment returns and their pattern by asset class.

o Inflation rates.

o Lifespan (or the planning horizon).

In recent years, several studies have addressed the question of what is a safe withdrawal strategy. These studies generally utilize Monte Carlo analysis or stochastic models to account for variations in investment returns and inflation rates. Most use a fixed lifespan, e.g., 30 years or attained age 95.

The case study described in this article also accounts for variation in the third major unknown–lifespan. This facilitates a more realistic look at the question of whether to insure against longevity risk, or the risk of outliving assets.

The client in this study has a nest egg of $500,000, which was assumed to be 40% invested in equities (24% in large cap, 8% in small cap and 8% in international) and 60% in fixed income (45% in bonds and 15% in money market). Two thousand scenarios were stochastically generated with the following variables year-by-year:

–Investment rates by asset class.

–Inflation rates.

–Mortality rates (based on the Annuity 2000 Mortality Table).

Note that stochastic mortality rates cause the client’s lifespan to vary. In each case, an annual income is withdrawn from the $500,000 nest egg. The income is adjusted annually for inflation and is specific for each scenario. A scenario is deemed successful if inflation-adjusted annual income is maintained over the client’s lifetime. The target success rate was set at 90%, i.e., inflation-adjusted income was fully maintained in 90% of the 2,000 scenarios.

The base case utilizes a systematic withdrawal program (SWP) for the entire $500,000 nest egg. Today, SWPs are the most common method for drawing income from a nest egg. Calculations were done for 6 client variations–male and female; ages 65, 70 and 75 (see Table A). In each variation, the system solves for the initial annual withdrawal amount that meets the 90% target success rate. The table shows both the initial annual withdrawal amount in dollars and as a percentage of the $500,000 nest egg.

Generally, the initial withdrawal rates are in the 4% to 5% range, which coincides with previous studies and current practice recommendations; however, there is some variation by age and gender.

The base case (see Table A) does not insure against longevity risk. So, two alternative cases were developed mixing a single premium immediate annuity (SPIA), life only option, with the SWP. The SPIA insures against longevity risk by converting part of the nest egg into a guaranteed lifetime income stream. Alternative I (Table B) allocates $125,000 (25%) of the $500,000 nest egg to an SPIA, and Alternative II (Table C) allocates $250,000 (50%) of the $500,000 nest egg to an SPIA.

Conclusions: A client can draw more income at the same 90% target success rate when an SPIA is added to the SWP. The percentage increase in income ranges from 6% to 13% in Alternative I (25% SPIA), and from 11% to 25% in Alternative II (50% SPIA). Generally, the income increase is greater for older ages.

Also, the SPIA alternatives provide a floor of guaranteed income for life while the base case (SWP only) does not. In the scenarios that fail, the base case SWP income generally falls to zero. For Alternative I (25% SPIA), there is a guaranteed lifetime income floor that ranges from approximately $10,000 to $14,000 per year. For Alternative II (50% SPIA), there is a guaranteed lifetime income floor that ranges from approximately $20,000 to $28,000 per year. With the SPIA alternatives, the client’s income level never falls to zero. This guaranteed lifetime income floor provided by the SPIA product helps to insure against the risk of living too long, i.e., longevity risk.

In summary, adding an SPIA to the SWP provides higher income (at the 90% target success rate) and provides downside protection (longevity insurance) with a guaranteed lifetime income floor.

But, there are trade-offs.

1. The SPIA product entails the client giving up liquidity. Most clients will need to maintain liquidity on a portion of their assets in order to fund life’s unexpected events. So, only a portion of the assets should be allocated to the SPIA.

2. The SPIA alternatives provide lower remaining asset values at death. In effect, by mixing in the SPIA, the client is trading some “estate” value for protection against outliving their assets. Intuitively, this trade should be attractive for most clients since maintaining financial independence during one’s lifetime generally has a higher priority than leaving an inheritance at death. (Note: Adding a certain period or refund feature to the SPIA can help offset the loss of “estate” value.)

In view of the case study, here are a few practical thoughts on insuring against longevity risk: Clients are often concerned about giving up control of their assets. However, one of their greatest fears is outliving their nest egg. The SPIA product can address this fear by providing the security of a guaranteed paycheck for life.

In addition, it may be helpful to establish a budget for longevity insurance. Some advisors suggest that a client have guaranteed lifetime income sources that cover basic (non-discretionary) expenses. If the client’s Social Security benefits and defined benefit pension payments are less than their basic expenses, they can fill that gap with an SPIA.

Finally, the SPIA product is best described as “living insurance.” The longer one lives, the more it pays.

This article originally appeared in the July 2007 issue of Income Planning, an online publication of National Underwriter Life & Health. You can subscribe for free to this monthly e-newsletter by going to .

Dennis L. Carr, FSA, CLU, ChFC is chief actuary with Lifetime Income Solutions Group, Louisville, Ky., a member of Western & Southern Financial Group, Cincinnati. His e-mail address is HYPERLINK “mailto:[email protected][email protected]


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