Most people are pretty familiar with the basic idea behind life insurance. Essentially, in the unfortunate event of your untimely death, the policy pays out a death benefit to your named beneficiary or estate—replacing income and providing guaranteed liquidity for your estate.
But what about the opposite risk?
What if, instead of getting insurance that pays out to your beneficiaries in the event you die too soon, what if you want insurance that pays out as long as you live?
All things considered; a long, healthy life is a good thing. But, for retirees on a budget, it can raise the specter of outliving your retirement savings—a situation financial planners call “longevity risk.”
Now, as it turns out, insurance companies are well-aware of the twin risks of dying earlier or later than anticipated. And they offer complementary financial products designed as a hedge against either (or both): life insurance and annuities.
Annuities are sometimes described as “reverse life insurance” because—at least on the surface—they are designed to protect against the opposite risk. Interestingly, though, the two products also have many similarities and can be used symbiotically as part of an estate or retirement plan.
Annuities vs Life Insurance
| Life Insurance | Annuities |
|---|---|
| Term or Permanent | Deferred or Immediate |
| Pays out when you die | Pays out over your lifetime |
| Provides income to your beneficiary | Provides income to you |
| Riders Provide Additional Value | Riders Provide Additional Value |
| Good for Retirement Planning | Good for Retirement Planning |
| A Contract | A Contract |
Life Insurance
A life insurance policy is a contract you make with the insurance company under which you pay premiums now in exchange for the insurance company’s promise to pay out a death benefit to your beneficiaries or estate upon your death.
There are two main types of life insurance coverage, term life and permanent life insurance policies.
Term Life Insurance
Term Life Insurance lasts for a period of time, as the name implies. Once the term ends the policy is no longer active, although life insurance companies will typically allow you to renew your term policy annually if you pay an increased premium.
Permanent Life Insurance
Permanent life insurance lasts for your entire life, as the name implies.Different types of permanent coverage include whole life insurance and universal life insurance.
Unlike term insurance, permanent life provides additional “living benefits” that increase the value of these products. The primary benefit of permanent life insurance is cash value.
Cash Value
Along with the death benefit, a permanent policy accrues cash value that steadily increases the longer the policy remains in place. Because the cash value itself accrues interest—and because many life insurance policies also pay dividends—permanent policies become a valuable financial asset that can be tapped in several different ways to help fund retirement.
A policy that stays in place long enough can accumulate enough cash value to be “paid up,” which means no further premiums are required and the surrender value (the amount the insurer will pay you if you choose to accept a cash payment now in lieu of a future death benefit) is close or equal to the death benefit.
Annuities
An annuity is a contract with an insurance company in which, in exchange for one or more premium payments, the insurer guarantees it will make regular annuity payments in the future.
Annuities can be fixed annuities and variable annuities. As the name implies, a fixed annuity has a fixed return set by the insurer. A variable annuity has a variable return determined by the return of the fund the annuity is invested in.
Annuities can vary tremendously depending on
- whether an individual annuity starts paying out right after it’s purchased (“immediate”) or sometime in the future (“deferred”);
- whether the annuity payments are guaranteed for life (“lifetime” or “life income”) or for a defined number of years (“term” or “period certain”); and
- whether the annuity’s value grows at a specific interest rate (“fixed”), based on investment performance (“variable”), or according to the performance of a designated equity index (“fixed indexed”).
SPIA
By way of example, a popular choice for recent retirees is what is known as a single-premium income annuity (“SPIA”). The annuity contract is purchased with one large, lump sum payment (often from retirement savings) and then pays out on a predefined schedule for the rest of the annuitant’s life. With guaranteed payments for life, SPIAs act as a hedge against the risk of living beyond life expectancy and exhausting retirement savings.
Commonalities Between Life Insurance and Annuities
Though life insurance and annuities are essentially insurance against opposing risks, the two products actually have quite a lot in common.
Both are purchased from life insurance companies, and both involve a trade-off of one or more premiums upfront in return for future financial benefits from the insurance company.
The premiums required for either product usually depend on your age, life expectancy, and health status. Typically, older applicants will pay higher premiums for life insurance but lower premiums for a life income annuity (everything else being equal).
Both products also have a cash value that grows and can be used as a means of support in retirement.
And, in either case, the growth is “tax deferred,” which means that the interest or other earnings do not result in any current tax liability until the money is actually received from the insurance company. This might sound like a trivial question of tax policy, but, in practice, deferred growth results in very real economic benefits.
Real economic benefits, such as…
Rather than losing some value to yearly income tax, all growth earned by an annuity or life insurance policy can remain in place, compounding and earning even more growth.
Over time, the total cash value is significantly increased as a result. And, by the time the earnings are actually received, there’s a good chance you’ll be retired and paying income taxes at a considerably lower rate.
Deferred Annuities
Deferred annuities are a particularly good way to limit your overall tax liability. If you purchase a deferred annuity during your prime working years, you won’t owe any taxes on the growth until the annuity starts paying out.
So, if annuitization doesn’t start until after retirement, you can often take advantage of a much lower rate. If the deferred annuity is “tax qualified,” the savings are even greater because you won’t owe taxes on the money used to fund the premium until after you retire.
Life Insurance Growth
Along the same lines, growth in a permanent life insurance policy’s cash value doesn’t result in any tax liability until the cash value is actually withdrawn—and then only if the amount paid out exceeds the premiums paid in.
If the policy is never cashed out and instead stays in place until the eventual death benefit is triggered, the payout won’t result in any tax liability at all, as death benefits from life insurance are not taxable income.
1035 Exchange
In recognition of the similarities between the two products, the Internal Revenue Code includes a special provision (§1035) allowing for conversion of a life insurance policy into an annuity without the need to pay income tax on the policy’s growth at the time of the transaction.
A “1035 Exchange” can likewise be used to trade one annuity for another, or to trade one life insurance policy for another, without any current income tax liability.
In either case, the new annuity or policy inherits the tax basis of the former asset, and income taxes are owed on growth when it is actually received—essentially like the payment had come from the original asset.
A final noteworthy similarity between annuities and life insurance is that both products offer scores of riders and options that can provide additional benefits.
For example, long-term care riders, which accelerate or increase payments to cover costs of long-term care, are available with many annuities and life insurance policies.
Differences Between Annuities and Life Insurance
Despite the similarities, life insurance and annuities have important differences as well. As mentioned above, the ultimate purpose of each product is different: an annuity pays you for getting old, while a life insurance policy pays your loved ones if you don’t.
Both products can help fund retirement, but annuities are more specifically geared toward that purpose. With life insurance, some of the premium is devoted toward underwriting the death benefit.
For the most part, life insurance policies require regular premiums over an extended period, and, when the policy matures, the beneficiary or policyholder gets a lump-sum back from the insurer.
Annuities, though, more commonly involve a lump sum payment, followed by payments from the insurer over time.
With that said, there are some life insurance policies that call for a single premium life insurance payment up front and annuities that allow for flexible premiums over time.
And, there are deferred annuities that pay out in a lump sum, and life insurance policies that allow for annuitization of the death benefit (or cash value) over time.
Flexibility
Both life insurance and annuities are flexible products, but the flexibility generally occurs at different times.
You see, once a policy is in place, life insurance offers numerous options for capitalizing on the policy’s value.
And with any given policy, you can choose to keep the policy in place or even overpay premiums to maximize the death benefit.
Or you can surrender the policy for cash or roll-over the value into an annuity.
And you might make a partial withdrawal of cash value or take out a loan against the policy.
Or you can exercise a “reduced paid-up nonforfeiture option,” under which the policy’s death benefit decreases but the need for future premiums is completely eliminated.
All of these options are available with most policies, and optional riders can allow for even more choices.
Versatility
The versatility of annuities comes more at the front end, when you’re selecting the annuity.
In most cases, you have multiple options for how and when an annuity pays out, how growth is measured, how long payments continue, and what happens if you die during the annuity’s term.
Once these choices are made and an annuity is in place, the best approach financially is usually to simply accept the contractual payments.
You can, though, swap one annuity for another through a 1035 exchange if the current payment structure is no longer right for your situation.
If you need immediate liquidity, you can surrender an annuity and cash out, though there are often substantial surrender fees involved, especially early on.
And there’s also the option of selling your right to future payments to a third party. But if you do so, you’ll be losing money when all is said and done.
What about taxes?
On the tax front, annuities and life insurance are treated similarly when it comes to payouts received during life, but the tax treatment is different when the payment comes after death.
Life insurance comes with a guaranteed, tax-free death benefit to beneficiaries.
Annuities can, and often do, provide for payments to the annuitant’s estate or heirs after death, but the death benefit isn’t tax-free the way life insurance is—growth is still taxable income.
So, if providing an inheritance for heirs, or a liquid asset to cover estate taxes, burial expenses, or estate debts is your primary goal, life insurance will likely be the better option.
With life insurance, premiums are almost always paid using after-tax money, so there’s no income tax deduction.
That’s the case for many annuities, too, but tax-qualified annuities are treated more like an IRA in that pre-tax money can be used for premiums, reducing current income tax liability.
On the back end, life insurance offers an effective means of reducing estate taxes because it can be removed from an eventual taxable estate without much trouble.
Advantages of Life Insurance versus Annuities
In general, life insurance focuses more on providing a means of support for loved ones or others who are financially dependent on the insured—and toward estate liquidity—while annuities lean more toward retirement planning.
With that in mind, the pros and cons of life insurance versus annuities often boil down to the specifics of your personal and financial situation, and to your individual preferences.
Life Expectancy
If your family history suggests that you stand a good chance of substantially outliving your actuarial life expectancy, a life income annuity is probably a smart investment.
If the idea that you might die early and not get back everything you paid in bothers you, period-certain options and premium refund riders are available to ensure that doesn’t happen.
Conversely, if you have a family history of early death, life insurance could be a vital financial asset, especially if you still have loved ones depending on your income.
Then, if you reach a point where replacing your income is no longer a priority, you can swap the policy for an annuity, borrow against your cash value or just cash out and use the money for retirement.
Liquidity
A lot can also depend on the nature of the assets you already own. If, for instance, your estate will have a high overall value but most of your wealth is tied up in illiquid investments (like real estate or business interests), life insurance is a great way to ensure your estate can pay taxes and satisfy creditor claims without having to sell off assets that are earning good returns or that you want to keep in the family.
An annuity can serve a similar purpose during retirement—providing a consistent income stream to cover fixed expenses and avoid selling other assets in down markets or when they’re earning good returns.
If you prioritize budgeting certainty and like the idea of an asset that guaranties respectable but unspectacular returns, annuities fit the bill. If you’re feeling pretty confident about your retirement position but need to lock down some liquidity for estate costs, permanent life insurance policies may be ideal.
Remember, if you decide down the road that you don’t need permanent life insurance after all, you can convert your policy into an annuity contract without much difficulty or cost.
