In a perfect world, everyone would be blessed with a long, healthy, comfortable retirement. In the real world, though, we know that a well-funded, pleasant retirement requires careful planning. And one of the biggest challenges in developing a solid retirement strategy is dealing with uncertainty.
You can’t be sure what will happen with inflation and living costs, interest rates, taxes, or investment performance. More fundamentally, you can never know for certain just how long you will live.
Just imagine for a moment you are planning to retire at age 65, and you’ve set aside enough to live comfortably for twenty years. In most scenarios, you’d be in pretty decent shape. After all, the average life expectancy in the United States is a little under 79 years, so you have a more than five-year cushion.
But what happens if…
You live to be 90 and run out of money? At that age, going back to work wouldn’t be easy, and Social Security alone might not even cover all of your fixed expenses.
The point of this illustration is not to scare people into working longer than necessary but to draw attention to a very real risk that all retirement planners need to take into consideration: longevity risk – or the risk of outliving your savings. Longevity risk isn’t anything new.
Social Security and public and private pensions are all designed to ensure that retirees have a lasting means of support. Even the ancient Romans offered lifetime pensions to retired legionaries as a reward for their service.
With continual medical advancements leading to longer lifespans as ever-fewer employers offer pensions, longevity risk has become a real concern for an ever-increasing percentage of the population.
As with most other risks, it’s possible to insure against longevity risk. In the world of consumer retirement planning, straight life annuities are one of the most effective financial products for doing so.
Also known as “lifetime annuities,” “lifetime income annuities,” or just “income annuities,” a straight life annuity is a contract between you and an insurance company under which you pay a large premium payment to the insurer and the insurer makes regular, guarantied payments to you for the rest of your life.
The essential feature of a life annuity is that the payments are guaranteed for life – no matter how long you live.
By contrast, term annuities pay out over a defined period of years and therefore are not quite as useful in addressing longevity risk.
What is a Straight Life Annuity?
When you purchase a life annuity, you are converting an upfront premium payment into a vested right to a reliable income stream for the rest of your life.
You can fund the premium from savings, from selling mutual funds or stocks, from an IRA or 401k, or by cashing in the surrender value of a life insurance policy through a 1035 Exchange.
Alternatively, subscription annuities allow for premium payments over an extended period until the annuity is fully funded.
Although straight life annuities are most commonly associated with retirement planning, they can be beneficial in other contexts as well.
Lottery winners and recipients of large legal settlements, for example, can ensure a steady income for life, avoid the risk of squandering a windfall, and reduce the ultimate tax bill by accepting payment in the form of a life annuity rather than as a lump sum.
Life annuities are also a popular tool for businesses looking to buy out a departing shareholder or partner’s equity interest.
A single premium immediate annuity, or SPIA, is funded with a lump-sum premium and begins paying out right away.
Deferred annuities, on the other hand, delay payments until a future date – allowing the insurance company to invest the entire premium before annuitization begins. The deferral period can be as little as one year or as long as forty years, though the delay is usually closer to five or ten years.
Straight Life Annuity Payments
Life annuity payment rates are determined based on your age and life expectancy, interest rates (both current rates and the insurance company’s expectations about future rates), and the size of the premium payment.
The insurance company tries to calculate the payments so that, if you live to your full life expectancy, you will receive all of the premium back with interest at a decent rate of return.
As a result, a 65-year-old who purchases an immediate life annuity will receive smaller payments than a 72-year-old who purchases an otherwise identical annuity because the insurance company anticipates making more payments to the former.
Along the same lines, deferred annuities tend to have bigger payments due to the later start date and because the insurance company has additional time to invest the funds before annuitization begins.
Fixed life annuities provide lifetime payments in an unchanging amount and, as a result, a predictable income stream throughout retirement.
For annuitants with a higher tolerance for risk, life insurance companies also offer variable annuities, with fluctuating payments tied to investment performance. Most variable life annuities let you choose from among a menu of mutual funds offered by the insurance company.
If the funds perform well, payments are higher. But if the funds perform poorly, payments decrease, though there is often a minimum payment amount regardless of investment performance.
Similarly, structured and indexed annuities link pay-out amounts to the stock market.
Indexed annuities typically come with a “no-loss” guaranty but also have an earnings cap limiting the annuity’s growth to around four or five percent.
Structured annuities come with a higher earnings cap but allow for some limited losses.
Insurance companies mitigate the risk inherent in guarantying lifetime payments by grouping demographically similar annuitants into risk pools.
On average, if an insurer issues one hundred annuities, about half of the annuitants will outlive life expectancy and half will die early.
The annuitants who end up receiving fewer payments effectively subsidize those who live longer in the same way that life insurance policies that pay out early death benefits are subsidized by longer-living policyholders.
Pros and Cons of Life Annuities
Within the retirement-planning context, the fundamental benefit offered by life annuities is long-term budgeting certainty and income continuity.
Straight life annuity payments are predictable and reliable, regardless of financial volatility or economic downturns, and thereby guard against longevity risk.
Frees Up Resources
A strategic purchase of a life annuity calculated to cover all fixed expenses (or to cover all fixed expenses when combined with Social Security) frees up other resources to invest in assets with greater growth potential.
That is, if you know you have enough guaranteed income to pay for food, health insurance premiums, utility bills, and property taxes, you have the flexibility to undertake investments with greater risks but also greater potential rewards.
A fixed life annuity has basically zero chance of principal loss. In the unlikely event that a highly-rated life insurance company fails, annuities are still covered by state guaranty associations up to the amount of the principal investment.
Each state association has a cap on the total loss it will absorb per annuity, so, if you want an annuity in an amount greater than your state’s cap, you should consider purchasing multiple annuities from different insurers.
Another attractive feature of life annuities is that they can be tailored to the annuitant’s specific needs and goals.
Most insurance companies offer dozens of different riders adding various benefits or addressing certain drawbacks of standard annuities.
The cost of the rider is generally either paid as a higher upfront premium or through corresponding reductions to the annuity’s regular pay-outs.
Depending upon how long the annuitant lives, fixed life annuities can be vulnerable to periods of high inflation eroding the buying power of the fixed payment.
However, cost-of-living and inflation adjustment riders, which increase payment amounts to account for rising prices, can be purchased to protect against increasing living costs.
No Death Benefit
In their purest form, annuities cannot be left to an annuitant’s heirs because the insurance company’s payment obligation ceases upon death. To address this concern, insurers offer death benefit riders that provide for payments to an annuitant’s estate or a designated beneficiary.
A “life with period certain” rider requires payments to continue if the annuitant dies before reaching a certain age.
Alternatively, a cash-refund rider pays out any remaining premium if the annuitant dies early.
Although riders add to the cost of an annuity, the benefits they provide are often worth the added expense.
Lower Returns vs Stock Market
Another common criticism is that the rate of growth for life annuities is below what can be earned, on average, by investing in mutual funds indexed to the stock market. Although this is generally true as far as it goes, it is really an apples-to-oranges comparison.
When you purchase a life annuity, you are buying the insurance company’s promise to make payments to you for life – not until you reach your life expectancy.
If you live twenty years longer than expected, the annuity will continue to pay out even after the entire premium has been paid back, in which case your overall returns will obviously be much higher.
Conversely, if you rely solely on stock market investments, unless you are investing enough to live off of earnings alone, you will eventually have to draw down your principal investment and start worrying about longevity risk, not to mention the anxiety that is part and parcel of having all your retirement income in the stock market.
Annuities cannot be readily tapped in an emergency, and so lack of liquidity is a fair criticism of life annuities.
After you purchase the annuity, you have limited access to the large principal investment other than through the regular pay-outs.
And if you do have to withdraw early, you will likely incur significant surrender penalties.
For this reason, life annuities are best used in combination with other assets as part of a comprehensive retirement strategy, and not as a sole means of support, so that other assets are available if an emergency expense arises.
If absolutely necessary, it is usually possible to sell the right to receive future annuity payments in exchange for a lump sum payment.
Taxation of Life Annuities
Like many other retirement savings tools, life annuities have tax advantages, depending in part on whether the annuity is “qualified.”
The distinction between “qualified” and “non-qualified” annuities boils down to whether the annuity was funded with pre-tax or already-taxed money.
Qualified annuities are funded with pre-tax money, like with an IRA. The annuity premiums are deductible for the year the contribution is made, and taxes are not owed until the money is received as annuity payments on the back-end. Qualified annuities are subject to tax penalties for withdrawals before age 59 and ½ and are also subject to minimum distribution requirements once you reach age 70 and ½.
Non-qualified annuities are funded with money that has already been taxed. Payments from a non-qualified annuity are only taxable to the extent the payment constitutes growth on principal – the remainder is non-taxable return on premium.
Both qualified and non-qualified annuities grow tax-deferred so that no taxes are owed on the annuity’s earnings until the money is actually received from the insurance company.
A life annuity is, at heart, a pension you purchase for yourself. When used tactically as part of an overall retirement strategy, life annuities provide both financial stability and a permanent hedge against longevity risk.
Now, will a straight life annuity be right for you?
Who knows, it could be. And here at I&E we’d love to help try and decide if purchasing a life annuity makes sense as part of your retirement plan and, if so, whether any of the available riders could help you and your family get the most out of the purchase. But if not, we’ll also be happy to provide you with some “alternative ideas” as well so that in the end, you’ll be protected as you grow older.
So, what are you waiting for? Give us a call today and see what we can do for you!