Tue, 4 Aug 2015
Christine Benz highlights the pros and cons of annuities and other longevity-hedging strategies.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. With life expectancies rising in the United States and across much of the world, many investors are worried about the prospect of outliving their money. I'm here today with Christine Benz--she is our director of personal finance--to look at some of the pros and cons of strategies to help protect yourself against this longevity risk.
Christine, thanks for joining me.
Christine Benz: Jeremy, it's great to be here.
Glaser: First off, it seems like, in a lot ways, increasing longevity is generally a good thing. But it does have this one potential problem of you having to pay for those extra years. What's a good first step for trying to figure out if you really do have enough money so that you don't run into these problems?
Benz: It's a huge question, obviously, but I think you want to take stock of a few key things. One would be your certain sources of lifetime income that you'll be able to draw upon in retirement. If you are one of those people who looks upon Social Security and maybe you've got a pension, and together those things are covering most of your income needs during retirement, you're not someone who needs to get overly concerned with longevity risk because you've got those lifetime income sources in place. If you are someone who does not have those lifetime income sources--maybe you just have Social Security plus your own savings in a 401(k) and other investment wrappers--you are someone who ought to be paying more attention to longevity risk.
Another thing, obviously, to key in on is your family history of longevity as well as your personal-health history. Certainly, as you get close to retirement, you begin to have a sense of your health issues and how those might affect your own longevity, so take stock of those issues as well. Also, remember that a lot of the work done in the realm of retirement planning has included pretty generous assumptions about longevity. So, when you look at, say, the 4% rule for retirement portfolios, that rests on a 25- to 30-year time horizon already. So, that is building in some fairly generous life spans for most retirees from the get-go. So, bear in mind some of the longevity assumptions that might be embedded in some of the frameworks that you are using for building out your plan.
Glaser: Let's take a closer look at some of these strategies or products--the first being deferred-income annuities. Can you tell us a little bit about what these products actually are?
Benz: In a lot of ways, they are the most direct hedge against longevity risk. It's simply an annuity that is set to pay out at a later date. You give the insurer a sum of your money when you are younger, and the idea is that they will start sending it out to you as a stream of income once you hit some predetermined year--maybe age 85, for example.
Glaser: What are some of the benefits of looking at deferred-income annuities?
Benz: The key benefit is that it allows the retiree to plan for his or her portfolio to last during a knowable time horizon. So, you can plan for that portfolio to last to age 85, then that deferred-income annuity will kick in after that point. So, it's attractive from that standpoint. They can also be a lot more cost-effective than, say, an income annuity that would start earlier in your life. The reason is that insurers, with the actuarial tables that they are drawing upon, know that many folks will not live past 85. And certainly, if they do make it to 85, they will not live many years past age 85. So, those annuities can be pretty cost-effective if you can purchase that longevity hedge without a substantial outlay.
Glaser: But is that also one of the biggest drawbacks--that you could give out this lump sum but then never actually see the benefit or be able to pass on that money to a family member?
Benz: Absolutely. That's the big drawback with this or any other annuity type. If you are someone who dies before you expected to, your money remains in the kitty. That's what allows the payouts from these annuity products to be higher than with plain-vanilla savings products.
Glaser: What about that immediate annuity? When would that make sense?
Benz: Immediate annuities are a much less direct hedge against longevity. Even though buying some sort of a lifetime immediate annuity means it will last for your entire life, it will start paying out earlier on in your retirement. So, it's not necessarily going to be as precise a hedge against longevity. The big benefit with an immediate annuity is that it's a very transparent market, a very liquid market. There are a lot of products out there, so it's easy to compare the payouts. There is much transparency for the consumer. There is much less transparency for consumers in the deferred-income annuities.
Glaser: What would some of the drawbacks of the immediate annuity be?
Benz: The same one that would be a drawback with the deferred-income annuity--the idea of plunking down some large lump sum that you may never back entirely. And then another big headwind for single-premium immediate annuities right now is the prevailing interest-rate environment. So, insurers know that if they take in client money that they have to earn today's interest rates on that money, so payouts are generally quite low relative to historical norms. That's why you often hear planners advise prospective buyers of annuities to potentially ladder those purchases over a period of years; that way they can potentially be able to experience higher payouts down the line with their future purchases.
Glaser: Of course, a more plain-vanilla hedging strategy might be just ratcheting up your equity exposure, trying to get more return out of your retirement portfolio. What do you think of a strategy like that?
Benz: I think that there is some appeal to such a strategy. Certainly, it doesn't entail parting with a big share of your portfolio. That's intuitively appealing. So, if you end up not living way past your average life expectancy, that money can pass on to your heirs or other loved ones or charity. And I think it makes sense regardless of whether you pursue some of these other strategies that we've already discussed. If you do go for some sort of annuity, you might also reasonably nudge up the equity exposure in your portfolio because, over time, we do see that equities tend to outperform cash and bonds. I think that's arguably going to be the case over the next couple of decades, given the very low yields that we currently have on bonds.
Glaser: But unlike those annuity products, there are no guarantees in the stock market.
Benz: That's the big risk. That's one reason why even if you decide to enlarge your portfolio's equity stake somewhat, you certainly wouldn't want to run with, say, a 90% equity portfolio in retirement. The risk of equities not performing in line with your expectations is just too great. So, you want to be careful on that front. It's also worth noting that the various annuity products that we just talked about are a way to neatly match your liabilities in retirement. That's not going to be the case by simply nudging up your equity portfolio. It will be a little more art than science, whereas the annuities can allow you to be pretty specific in terms of matching your liabilities to your income stream.
Glaser: Christine, thanks for your thoughts on longevity risk today.
Benz: Thank you, Jeremy.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.