There was a recent post at the Times’ Bucks Blog about Longevity Insurance that caught my attention. I decided to run some numbers to see what returns are implied in the current prices of longevity insurance and compare that to the risks, and the alternative of just keeping your money and investing it yourself. Lets dive in.
Longevity insurance seems to be just a fancy new name for a type of product that’s been around for a long time, a deferred annuity. As the Bucks Blog says in the title of their post longevity insurance is just a way of buying down the risk of living too long. The blog post goes on to describe two ways of using longevity insurance:
With the first way, you might think about it as a way to prepay for an annuity (or a pension) well before you plan to use it. That makes it cheaper than an immediate annuity, because, well, there’s a chance you’ll die before you begin to collect. In addition, the insurance company has the advantage of investing your money over a longer period of time. You might buy the annuity at age 55, but decide to begin collecting it at age 67, for instance.
But it can also be used as a pure insurance policy — hence the name, longevity insurance. You can agree to begin collecting the insurance at a much later date in the future, like your 85th birthday. So if you live past your life expectancy, you’re covered. And since most people don’t know when they’re going to die, this allows you to spend down your retirement savings more liberally because you know your payments will kick in later . The big risk, of course, is that you won’t see a dime because you die before you can collect. (emphasis mine)
I want to focus on the second way, as pure longevity insurance and see if the costs and risks of longevity insurance make it worth considering. I am particularly interested in the statement I emphasized, that longevity insurance may allow a retiree to ‘spend down your retirement more liberally.’ For this example, I’ll use a 55 yr old newly retired couple with a life expectancy of 85 yrs. A conservative retirement plan usually calls for planning for a life expectancy 10 yrs longer than the life expectancy tables just in case. So, this couple is looking at having their portfolio last for 40 yrs (until 95 yrs of age). But now with longevity insurance they have an option. Buy a longevity insurance policy to cover them in the event they live beyond 85 and plan their retirement withdrawals for a 30 yr period. Is it worth it? It depends on the cost of the longevity insurance. Lets take a look at the numbers.
The Bucks Blog posts says it would cost this 55 yr old couple $20,340 for a longevity insurance policy that pays out $1,000 per month starting at the age of 85. Lets say this couple needs $4,000 per month of income to cover their expenses so they are looking at spending $81,360 for this policy that kicks in at 85. Now we can calculate what the implied investment return is in this policy. I assume that at age 85 the couple lives another 10 years, to 95. The calculation is then at what rate of return does the insurance premium need to grow in order to provide enough funds for the 85 year old couple to live another 10 years. We can use the concept of safe withdrawal rates to figure out how large the portfolio needs to be to safely provide income for 10 yrs. For a 10yr period the safe withdrawal rate turns out to be 8.4%. Thus the portfolio at 85 years of age needs to be $143,128. The implied rate of return for the 30 years from age 55 to 85 is then 6.72% per year. Is that a good deal or not? It’s not great but it depends on your outlook for future investment returns. But first, lets look the difference this insurance policy would make on the couple’s retirement period from age 55 to 85.
Without the insurance policy the 55 yr old couple is looking at a 40 year retirement period, their 85 year life expectancy plus 10 years for a margin of safety. The safe withdrawal rate for this 40 yr period is 3.8%, 0.2% less than the standard 4% for a 30 yr retirement period. Now their choice is to buy the insurance policy and use the higher 4% withdrawal rate knowing the last 10 years, from 85 to 95, is covered by insurance. Of course, buying that policy today costs them some of their principal. Is it worth it? Running through the numbers shows that that by buying the insurance policy the couple’s annual income goes from $48,000 per year down to $47,272 per year despite the higher withdrawal rate of 4%. In other words, the increase in withdrawal rate is not enough to offset the reduction of principal required to pay for the policy. From this perspective, the longevity insurance policy is not worth it. It does not allow the couple to spend their retirement down more liberally as claimed.
And it gets worse for the insurance option. I’ve stacked the deck in their favor. My analysis completely ignored inflation while the safe withdrawal rates completely account for inflation. That $4,000 promised starting at the age of 85 is in today’s dollars. In 30 years most likely that $4,000 is going to be worth half of that. Of course, you can buy an inflation index option in the policy but that reduces the promised payouts substantially and makes the numbers worse. And of course the insurance option is not without risks. The biggest risk being that the insurance company may not be around in 30 years. The counter argument is that federal and state regulation is very strict for insurance and that this is a small risk. Sure, that is what they said about AIG and all the big banks. Also, there is the risk you die before 85 and you or your family never see any of the money. Then there is the loss of flexibility. Once you pay the premium its gone. You lose the flexibility to change your mind and spend that money in other ways. Maybe 10 years later you decide that its worth taking the chance and rely on social security and medicare in your final years.
Of course, on the other hand, their is the risk that the 4% safe withdrawal rate fails in the future. This is why I think its useful to look at the implied rate of return in the insurance policy. The implied rate of return of 6.72% for this longevity policy is quite low by historical standards. Even at today’s asset prices a well allocated passively indexed retirement portfolio has very high odds of crushing this 6.72% implied return. This low return on the insurance policy is primarily driven by the low interest rate environment. Insurance companies by law are required to keep the majority of their investments in bonds. When interest rates begin to rise these types of insurance policies will begin to be better value but not so today.
In summary, at today’s current prices longevity insurance is not worth it. The implied investment returns are not worth the offsetting risks and loss of flexibility. Of course, everyone needs to judge these risks for themselves and for some the peace of mind of the longevity policy will be worth it. However, in general even if you think longevity insurance may be right for you its is worth waiting at the minimum for interest rates to rise in order for the implied investment returns in the policies to go up.