“Nothing is certain but death and taxes,” Benjamin Franklin once said. That was in the 18th century. The 21st century adaptation might be, “nothing is certain but longevity and taxes.”
Longevity is a known financial risk and its importance will grow year after year, right along with consumer need for income annuities.
But longevity is not well understood. Too often retirement planning ends with addressing income needs only through average life expectancy, which is about age 85 for male annuitants and age 87 for females who currently are age 65.
Planning only through life expectancy is like pretending that longevity risk does not exist. In fact, longevity risk begins at life expectancy–the risk that someone will live longer than average. There is significant and growing probability of living to age 90, 95, 100 or more.
This means that, when planning for the future, individuals need to recognize the possibility of a very long life and the uncertainty of how long that might be.
Life expectancy for annuitants is actually higher than the ages commonly cited. Two important factors contribute to this. First, annuitants are healthier than the general population because annuities are generally purchased by individuals with above-average health who figure they will gain the most advantage from an annuity purchase. Also, mortality improves each year, adding approximately 1.5 years of life expectancy; this is usually overlooked.
Furthermore, longevity improvement will be magnified if significant life-extending medical breakthroughs occur.
Annuities can address longevity risks in all markets, but high income retirees should not be overlooked. Annuity purchasers with high annual payouts show mortality as much as one-third lower than purchasers of small annuities, according to research published by the Society of Actuaries. At age 65, each 10% reduction in mortality indicates an approximately one-year increase in life expectancy. This suggests that the planning horizon should be approximately three years longer for higher income individuals, who are above-average candidates for annuity solutions because they are positioned to benefit the most.
By comparison, an individual of upper-middle to high net worth who has planned for retirement based on current population data has likely underestimated life expectancy by 4 to 5 years–an underestimate of 20% to 25%.
Retirees often respond to longevity risk in one of two ways. The first is to live frugally in retirement, spending only income and gains and not touching principal. The second is to live the desired lifestyle in the early years of retirement with the expectation of slowing down as they get older so they won’t need as much income. Both are forms of self-insurance.
But, just as it is difficult for an individual to self-insure one’s own mortality risk (hence the need for life insurance), it also is difficult for a retiree to self-insure his or her retirement.
What is the best way to manage longevity risk for clients? Of course, Social Security is a start. Beyond that, the traditional approach has been an annuity with a portion of the benefits payable only while the annuitant lives, such as 10 years certain and life; this is still a good solution.
A more recent solution is a deferred start income annuity. For example, a small single premium paid at age 65 provides an income beginning at age 85, with no death benefits or surrender benefits. This provides a very efficient and low cost income guarantee for the later years, when income management can be very challenging due to advanced age or depleted assets. Such an annuity must be viewed in context with the balance of a retirement portfolio that it is protecting and making possible greater freedom of investment choices.
Another approach to longevity risk protection is through guaranteed lifetime withdrawal benefits on accumulation annuities and some mutual funds. These can provide investment protection denominated in longevity benefits, while providing well-rounded longevity protection if the account value is annuitized when investment returns are favorable.
The most difficult problems to solve are those that people do not see. The financial risk of increasing longevity is hidden inside the good news of increasing longevity. Now is the time to fully educate retirees and draw upon the solutions that already exist.
Noel Abkemeier, F.S.A., is a consulting actuary with Milliman, Inc., in the Williamsburg, Va. office. His e-mail address is email@example.com.