Fewer workers expect traditional pensions when they retire these days, yet most also are acutely aware that longevity is rising–and that they run the very real risk of running out of money at an advanced age.
These concerns have boosted awareness of the importance of optimizing Social Security and have sparked growth of a relatively small category of annuity sales, the deferred income annuity.
The deferred income annuity is an offspring of the more basic single premium immediate annuity. Both offer ways to purchase guaranteed lifetime payments as a way to bolster retirement security. As their names suggest, the single premium immediate annuity starts payment immediately upon purchase, while the other defers payments to a later date. Deferred income annuities that start income at an advanced age–say, age 80 or 85–intend to provide “longevity insurance.”
Expected longevity for men and women at age 65 has jumped more than 10% since 2000, according to the Society of Actuaries. Men who reach age 65 can be expected to live to an average age of 86.6, and women to 88.8. But 31% of women who reach age 65 will make it to 90. And for those with better health, the figure rises to 42%.
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But which is the more effective hedge against longevity risk–the deferred or single premium immediate annuity? The question crossed my radar following a recent column I penned for The New York Times on longevity risk.
Joe Tomlinson, a financial planner and actuary based in Greenville, Maine, who has done extensive research on retirement planning, created a custom projection for the column illustrating the challenges of managing longevity risk with savings alone. Using Monte Carlo analysis, we illustrated the case of a hypothetical couple with a $1 million nest egg to show that even fairly affluent households run the risk of retirement plan failure due to longevity–with failure defined as a forced, sharp cut in living standards when savings are exhausted.
Filing for Social Security at age 65 and living off savings produced a 47% chance of plan failure, with a $168,000 shortfall in resources. Not good.
Next, we delayed the couple’s Social Security filing to age 70. Tomlinson believes delaying Social Security should precede any consideration of an annuity in most cases, because the return on delayed filing–roughly an 8% bump in monthly benefits for every 12 months of delay–offers a payout that no annuity can match.
Delaying to age 70 to claim benefits sharply reduced the risk of plan failure to 38%. Just as important, the corresponding lifetime shortfall was much smaller: $58,000. Then, Tomlinson mixed in a single premium immediate annuity purchase at age 70–that reduced the failure risk to zero.
Single premium immediate annuities and deferred income annuities are both legitimate tools for hedging longevity risk, but Tomlinson prefers the former. He thinks the latter exposes buyers to worrisome amounts of stock market risk while waiting for payments to begin–and he said as much in the New York Times column. That sparked an interesting exchange of views with Matt Carey, chief executive of Abaris Financial, a 3-year-old online startup that sells income annuity products. The company’s intent is to use technology to simplify the annuity-buying process, and to wring out expense.
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