Longevity insurance, while not inexpensive, guarantees continued income indefinitely into advanced old age
The financial crisis has put front and center people's fears of running out of money in retirement. According to a recent consumer retirement study by McKinsey, 61% of defined-contribution participants said they were interested in an investment option that provides guaranteed income in retirement.
Jason Scott, head of the retiree research center at Palo Alto (Calif.)-based Financial Engines, the investment adviser founded by Nobel Prize-winning economist Bill Sharpe, argues that the simplest, least expensive way to get that guaranteed income is with a relatively new product known as longevity insurance. These deferred annuities start paying out long after your retirement has begun and are currently offered by insurers such as MetLife (MET) and Hartford (HIG). Scott advises buying the insurance at age 65 and starting the payout at 85, because it's cheaper since the chances of surviving each year are decreasing, and he would forego any extras such as death benefits. With this approach, you pay much less for future retirement income than its full value. Says Scott: "There's more bang for the buck for those farther-out years."
What you want to do, Scott argues, is allocate enough to the longevity annuities so you have the same level of spending in the first two decades of your retirement (from your portfolio) and after 85 (from the guaranteed income). That typically means 10% to 15% of your retirement assets should go to the longevity annuity. If you've got a $1.5 million portfolio at retirement, for example, it might mean spending $200,000 on longevity insurance that would kick in at 85. Thus you're assured of not being broke if you live to 95, and you can spend down that remaining $1.3 million in the first 20 years of your retirement. By buying at 65 and starting paying out at 85, a planning nightmare becomes relatively simple. "You no longer have to hold back a huge amount of income in case you live past 85," Scott says.
Sounds great, but what are the drawbacks? Like most insurance products, the plans are not cheap. Also, in these uncertain times, you'll want to choose your insurer wisely. "Annuities can be an effective tool for those who need income, but you need to be careful because they are only as safe as the insurance company offering them," says financial adviser Ric Edelman. You'll want to evaluate your insurer's financial strength, including its credit rating.
There are certain cases where you shouldn't buy. It might sound grim, but if you have major health problems, you may not need one. Also, if you're strapped for cash when you quit working and fear you won't be able to cover expenses in case of a medical emergency, it may be better to keep the cash on hand. Conversely, if you've saved well and have a sizable estate for your children and won't risk running out of cash in retirement, you may not need the insurance.
Given how difficult it is to make assumptions about how big your 401(k) balance might be when you retire, there's no need to purchase longevity insurance until you're on the brink of retirement, Scott says. "You don't want to overbuy. You don't want to have $100,000 a year kicking in at age 85 and you're struggling to put food on the table from 65 to 85."