Longevity insurance

Longevity insurance,[1] insuring longevity, also known as a longevity annuity[2] or deferred income annuity,[3] is an annuity contract designed to provide to the policyholder payments for life starting at a pre-established future age, e.g., 85, and purchased many years before reaching that age.

General description

Longevity annuities are like "reverse life insurance", meaning premium dollars are collected by the life insurance company by its policy holders to pay income when a policy holder lives a long life, instead of collecting premium dollars and paying a death claim on a policy holder's short life in ordinary life insurance. Longevity annuities use mortality credits to pool money and pay out the remaining policy holders' claims, this being living a long life.

The term "longevity insurance" comes from this type of annuity being insurance against unusually long life. It may seem odd to insure against an event that most people would welcome. However, living a very long time would strain many people's financial resources, just as a fire which destroys their house would strain many people's finances if they didn't have fire insurance. The logic that makes fire insurance a prevalent means for coping with the financial risk of house fires would seem to argue for greater use of longevity insurance for retirement planning: Few people will live to a very old age, so it doesn't make sense for everyone to try to cover that possibility with savings and investments. (The same type of reasoning applies to house insurance: because few people will experience house fires, therefore it is not realistic to expect everyone to save and invest specifically for purposes of house replacement.) Longevity insurance is not designed for the early retirement years, so it is not intended as a complete retirement plan by itself.[4]

For example, a person might pay $20,000 from his or her retirement savings at age 60 to purchase longevity insurance that would pay $11,000 per year starting at age 85 and continuing until death. These numbers are made up, but are based on actual terms offered by at least one major insurance company in November 2011. Thus, in this example, if the person lived to 95, they would receive $110,000 on their $20,000 investment (10 years at $11,000/year). This is a rate of return that far exceeds that available at prevailing interest rates on government bonds. The economic reason for the high return at low risk is that one is giving up any claim on that initial $20,000 investment on behalf of one's heirs. If the person dies before 85, the insurance company pays nothing to them or their estate. (Some companies offer optional features that would modify this, so there would be a death benefit or so they would have the option of starting payments sooner, but taking these options would substantially reduce the annual income the policy would pay at age 85.)

The benefit is generally paid in the form of a guaranteed income stream for the remainder of the individual's life (as in the above example), though alternative benefit forms may be provided depending on the terms of the actual policy. Life insurance companies in the United States that offer longevity policies include Metropolitan Life Insurance, New York Life, Pacific Life, Principal, Lincoln, Symetra Life Insurance Company and Hartford Insurance among others.

The main use of these products is to provide retirees with a way to stretch their retirement resources to cover the possibility of living to a very old age. The likelihood that many buyers of such an annuity will not live to collect on it allows the insurance company to pay relatively high returns, higher than are available on low-risk investments, to the fraction of buyers who do live that long, i.e., mortality credits.[4]

Qualifying Longevity Annuity Contract (QLAC)

The benefits of a longevity annuity in USA were increased in 2014, when the U.S. Treasury Departmeni issued a new rule[5] allowing the purchase of a Qualifying Longevity Annuity Contract (QLAC),[6][7] also known as Qualified Longevity Annuity Contract,[8] within an IRA or an employer tax-qualified retirement plan, without having to include the value of the annuity in the annual required minimum distribution (RMD) at age 70 1/2, which is taxable as ordinary income. That effectively reduces the amount of the IRA or employer plan subject to the required distribution, resulting in a tax saving every year until the payments eventually begin. Once the payments begin, the QLAC payout automatically meets any RMD requirements for the payout amount. (These payments are then also taxed as ordinary income.)

Definition of a QLAC

In order to be a QLAC, the longevity insurance contract must meet a variety of specific provisions according to the 2014 final rules.[5] It must have no cash value and required payments must begin no later than age 85, specifically, the first day of the month next following the IRA owner's or employee's attainment of age 85.[5] The QLAC must provide fixed payouts (e.g., the benefits cannot be variable or equity-linked such as an fixed index annuity[9]). There may be a cost-of-living or inflation adjustment as well as possible joint spousal benefits. The final regulations also allow for return-of-premium death benefits, both before and after the annuity starting date, so long as the death benefits are distributed no later than the end of the calendar year following the year in which the IRA owner or employee dies, or in which the surviving spouse dies, whichever is applicable.[5]

The QLAC can be purchased with up to 25% of total pre-tax assets (IRA or employer tax-qualified retirement plan), but no more than the premium limit $125,000. If an annuity contract fails to be a QLAC solely because premiums for the contract exceed the premium limits, either percentage or amount, then the contract will not fail to be a QLAC if the excess premium is returned to the non-QLAC portion of the IRA owner's or employee's account by the end of the calendar year following the calendar year in which the excess premium was paid.[5]

QLAC in retirement income planning

In planning a retirement, a major unknown is the length of one's lifetime and therefore how long one's resources should last, which is sometimes called the time horizon problem. A benefit of the longevity annuity is that it can address this issue, say from age 85 on, and thus can free up one's resources to plan efficiently for a known length of time, say from age 65 to age 85. The question is then: how efficient is a longevity annuity like a QLAC as part of a retirement income portfolio?[4]

The returns of a longevity insurance (ignoring fees) are from the principal, interests, and mortality credits. Since insurance companies typically invest in relatively safe fixed-income securities, e.g., bonds, the added mortality credits in a longevity annuity can make it more efficient (higher return) over the long run that a bond portfolio. Because of the mortality credits accrued during the deferral period, the time period between the purchase of a longevity annuity and when the longevity annuity payout begins, longevity annuities can be more efficient over the long run than immediate annunities, all else being equal. Detailed modeling has shown this to be the case: longevity annuities like QLACs are more efficient (higher return) than bond portfolios and, in most cases, immediate annuities over the long run.[3][4] A downside of a longevity annuity like QLAC is that it is illiquid and lacks the sizzle of equities.[10][11]

Deferral of Social Security income, say from age 62 to age 70, has a similar effect on payouts as in a deferred income annuity (another name for longevity insurance); mortality credits can accrue during this deferral period, say from 62 to 70. Because it is price based on 1983 interest rates and mortality rates (1983 was the last time it was changed), delaying Social Security is much more efficient over the long run than any QLAC can ever hope to be in the current low-interest rate environment.[10][11]

In the current environment of low interest and equity growth, which will change in unpredictable fashion in the future, the ones giving the largest return in the latter years of a long lifetime (upper quartile of life expectancy) appear to be: first, delaying Social Security as long as possible; second, equities; third, longevity annuities like QLACs, especially purchased early; fourth, bonds. Future changes in the environment can easily rearrange the efficiencies of these various elements; efficiencies based on mortality credits are most robust. Conservatively, a QLAC can be a diversifier, introducing mortality credits, to a bond portfolio. Detail models of optimal mix of these elements within a retirement income plan are complex[3] and depend on too many variables beyond the scope of this article on longevity insurance.

Risks

The insurance company is legally obligated to make the payments stipulated in the longevity annuity contract, but this obligation might not be enforceable if the company goes into bankruptcy. Therefore, prospective purchasers are generally advised to investigate the financial strength of the issuer before buying longevity insurance, and to consider splitting whatever amount they have earmarked for this purpose among several different contracts from different companies, so that if one goes bankrupt they will still have income from the others. In the United States, states generally require insurance companies to be members of state guaranty associations, which would very likely pay at least some portion of the benefits promised if the insurance company went bankrupt.

References

  1. ↑ Milevsky, Moshe A. (2005). "Real Longevity Insurance with a Deductible: Introduction to Advanced Life Delayed Annuities (ALDA)". North American Actuarial Journal. 9 (4): 109–122. doi:10.1080/10920277.2005.10596229.
  2. ↑ Scott, Jason S. (January 2008). "The Longevity Annuity: An Annuity for Everyone?". Financial Analysts Journal. CFA Institute. pp. 40–48. Retrieved 17 April 2017.
  3. 1 2 3 Blanchett, David (28 October 2014). "Allocating to a Deferred Income Annuity in a Defined Contribution Plan" (PDF). Morningstar working paper. Retrieved 17 April 2017.
  4. 1 2 3 4 Kitces, Michael E. (2014). "Understanding The Longevity Annuity And Its Potential Role In Retirement Income" (PDF). The Kitces Report, July/August 2014. pp. 1–15. Retrieved 17 April 2017.
  5. 1 2 3 4 5 "Longevity Annuity Contracts: A Rule by the Internal Revenue Service on 07/02/2014". Federal Register. Retrieved 17 April 2017.
  6. ↑ "Qualifying Longevity Annuity Contracts: Frequently Asked Questions (FAQs)" (PDF). Defined Contribution Institutional Investment Association. December 2014.
  7. ↑ Constantijn W.A. Panis and Michael J. Brien (24 October 2016). "Innovations and Trends in Annuities: Qualifying Longevity Annuity Contracts (QLACs)" (PDF). Department of Labor.gov. Deloitte. Retrieved 17 April 2017.
  8. ↑ William H. Byrnes and Robert Bloink (January 2015). "Longevity-Pegged Annuities: What CPAs Need to Know about the New Rules". The CPA Journal: 65–66.
  9. ↑ http://www.QLACs.net
  10. 1 2 "Longevity annuities a good retirement tool?". bankrate.com. January 2016. Retrieved 19 April 2017.
  11. 1 2 Iacurci, Greg (January 2016). "Longevity annuities better deal than bonds, immediate annuities, but lag equities". Investment News.com. Retrieved 19 April 2017.
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