Why lifetime annuities can offer valuable “longevity insurance”

Lifetime annuities as an investment tool @Zimmytws -stock.adobe.com

Having a financially successful retirement requires replacing a substantial portion of your working income. It’s why Social Security was created. Most people, however, won’t get sufficient Social Security benefits (they average about 40 percent of pre-retirement wages) to live the life they desire. Most people also don’t get employer-provided pensions.

That’s why our laws provide tax advantages that encourage people to save for retirement via qualified retirement plans (IRAs, Roth IRAs, 401(k)s and the like) and various types of tax-deferred annuities.

Lifetime income annuities, nevertheless, are underutilized. They offer longevity insurance against the risk of living to a great age and running out of money. The annuity owner pays a single premium to transfer that risk to a life insurance company.

The magic of mortality credits benefits all buyers

Lifetime annuities work because they use “mortality credits.” This is the money that’s left over when an annuity owner dies earlier than average, to the benefit of those who live longer than average. Think of an annuity as the opposite of life insurance, which protects survivors against the risk of loss of income from a breadwinner dying prematurely. Longevity insurance—the lifetime annuity—protects those who live a longer-than-average life.

The greatest benefit goes to the annuity owners who exceed their life expectancy and continue to collect annuity payments. But those who die earlier than average also get a great benefit. Because annuity owners know that their future income will be guaranteed for life, they can spend more freely than otherwise and don’t have to scrimp and save.

Research shows that having a guaranteed income reduces worry and promotes happiness when you’re retired. Furthermore, retirees with a guaranteed income can take on more risk in the stock market if they like because any future gains there will be like dessert rather than the main course.

An average 65-year-old man will live to 83. The insurance company uses that figure—along with prevailing interest rates, expenses, profits and the starting date for payments—to calculate how much monthly lifetime income it will guarantee a 65-year-old male buyer today.

In a large group of these men, a significant percentage will pass by age 83. The insurer calculates those mortality credits to figure out how much lifetime income it can afford to offer to the entire group of buyers, including the portion of 65-year-olds who will live past 83.

You can self-insure against longevity risk by investing in stocks, bonds, and savings. But you’d need to sock away 25% to 40% more than with an annuity because you won’t have the advantage of risk-pooling and mortality credits, a Wharton Financial Institutions Center study concluded.

Lifetime annuities keep paying even once you’ve gotten your money back

Part of each annuity payment you’ll receive includes the return of your premium. This portion is not taxable because it’s your own money coming back to you. It may or may not be the larger portion, but in any case, it will be significant, and you’ll enjoy a reliable stream of partially tax-exempt income. The non-excluded portion is the interest income the insurer pays you. It’s taxed as ordinary income.

If our 65-year-old lives past 83, his payments will keep coming, thanks to mortality credits, even though his entire premium will likely have been repaid. Once he has gotten back his entire premium, the annuity income will be fully taxable (unless the annuity is held in a tax-free Roth IRA). But at this point, that money is coming out of the insurer’s pocket, using accumulated mortality credits.

No other financial product keeps producing guaranteed lifetime income after your principal has been used up. Once you cash in a bond or a stock and spend the proceeds, it’s gone.That’s the magic of an annuity.

Defined-benefit pensions (the traditional kind that guarantees lifetime income) and Social Security work similarly. With a lifetime annuity, you turn over some of your savings to a life insurer in return for what amounts to your own customized private pension.

You can even dedicate part of your IRA holdings to a special type of lifetime annuity called a QLAC.

Should you buy an income annuity?

Most top independent experts often agree that it makes sense for retirees to annuitize a significant portion of their savings. An annuity can replace your fixed-income (bond and money-market) allocation. Even though many financial gurus recommend transferring a portion of your liquid assets to a lifetime annuity, the right amount, if any, depends on your circumstances and goals.

Here are some questions to ask yourself before buying:

• How much income will I get from Social Security and other sources? And how much more will I need?
• Will I need additional income for anyone else besides myself?
• How much income will my spouse need to replace if I predecease him or her?
• When do I expect to need income payments?
• Do I have enough cash reserves to meet expected needs? (If your savings are modest, you may not be in a position to buy an income annuity, which is not liquid.)

Once you’ve decided to buy, there are a huge number of options to consider, foremost among them, when you want to set the payments to start. The longer you delay the starting date, the greater your future income will be.

In a competitive market, insurers have an incentive to offer attractive income payments to attract buyers while still making a profit too. Each company has its way of pricing annuities, so it pays to shop around. Because interest rates are much higher than they were a few years ago, insurers now offer higher annuity income payments today.

If you do purchase a lifetime annuity, remember that it’s the mortality credits that enable insurers to offer a product with unique features that guarantee your income for decades.

Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. Ken is a nationally recognized annuity expert and widely published author. A free rate comparison service with interest rates from dozens of insurers is available at https://www.annuityadvantage.com or by calling (800) 239-0356.