Thu, 13 Sep 2012
Morningstar retirement expert David Blanchett covers the pros and cons associated with the key longevity insurance products.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
The average American who retires at age 65 can be expected to live 20 more years, and many people will live much longer than that.
Joining me to discuss some of the key products to help hedge against longevity risk is David Blanchett. He is head of retirement research for Morningstar.
David, thank you so much for being here.
David Blanchett: Thank you for having me.
Benz: So, David, one of the key products to hedge against longevity risk is the whole suite of annuities, but first let's discuss exactly what is longevity risk. On the surface it seems like a really good thing to be able to live as long as you possibly can, but there are certainly some financial risks there?
Blanchett: So, longevity risk is a good thing in some ways; it's the risk of living too long. We all want to live long lives, but people don't plan for 30 or 40 years in retirement. If we go back 30 or 40 years ago, people had defined benefit plans. You had investment types that provided income for life.
Well, today's generation of savers, they have 401(k)s and IRAs, and there is no guarantee component of lifetime income. So, the risk for them, the longevity risk, is the risk that they're going to not have enough money to live or pay for their retiree expenses for their lifetimes.
Benz: You have noted that there is research out there showing that this is a hugely pressing concern for today's crop of retirees.
Blanchett: There was a study done by Allianz Life, and they asked retirees, which are you more afraid of: death or outliving your resources. And 61% said outliving their resources. So, clearly the idea of outliving your available spending is significant for many retirees.
Benz: Certainly the volatile financial markets have contributed to that sense of uncertainty.
So, let's outline some of the key products that are out there. Annuities in general do provide some hedge against longevity risk. Let's start with the most vanilla, oldest product out there: the single premium immediate annuity, whereby you fork over your money and you get a stream of income through the rest of your life. What is the key advantage to such a product?
Blanchett: So, immediate annuities have been around for, I think, thousands of years. They are the simplest, and like you said, you're just trading $100,000 for income for life. So, there is no worry about monitoring the money. Once you've done it, you receive this paycheck, so to speak, for the rest of your life. So, it makes it very easy to transfer these funds, and there is no worry about can I outlive it. So I think that's the simplest and easiest way to kind of create income for life.
Benz: Also generally speaking the cheapest type of [annuity].
Blanchett: It is. There are all different kinds of insurance now to hedge against longevity risk, and this tends to be the cheapest because it is the most plain-vanilla. There are underlying sub-account fees, and there is going to be a commission probably when the insurance agent sells the product, but there are not that ongoing kind of fees involved to other types of products.
Benz: A lot of transparency there for the consumer...
Blanchett: Yes. It's really easy to compare. It's the easiest product to compare. It's like life insurance, because you know what you're going to get for a given price. There are no underlying hidden fees that would affect the benefit at all.
Benz: So let's talk about the disadvantages to SPIA...
Blanchett: The one main disadvantage in my opinion is that it's an irrevocable decision. So, once you go out and you purchase a SPIA, you've traded that income or that cash flow for a guaranteed income amount for life. And why that's difficult is because right now, interest rates are very low--they're new historic lows--and so if you go out today, for example, and you buy a SPIA, then you're trading in a sum of cash for a fixed, relatively low, guaranteed income for life.
Benz: Let's talk about another type of product. It's the fixed deferred annuity, often called and marketed as longevity insurance. Let's talk about how that works, because that may be somewhat less familiar to people than the SPIA.
Blanchett: I call this reverse term insurance. So term life insurance, you only receive the benefit if you die. With longevity insurance, you get the benefit if you survive to a certain point. So, for example, I would say I want $100,000 of income if I live to age 90, and I'm currently age 65. So, I would give an insurance company some money today, and if I lived age 90, I'll receive that amount of income as long as I would have lived. So, the obvious risk there is that if you don't live to age 90, you've lost that potential income.
Benz: But the big benefit, it seems, is that as an investor it allows me to plan for a knowable time horizon, so I can plan through 85, or whatever my normal life expectancy is. If I happen to exceed that, I'll have my hedge built in.
Blanchett: I think that's why it's so great, because it really helps you kind of hedge against that "if you live too long" scenario. Annuities work in different ways, but this type of product works in a way that allows you to say, OK, I want to go ahead and enjoy the next 20 years, and I'm going to know for certain at that 20-year mark, or 25, whenever it is, that I'm set for the rest of my life.
Benz: OK. So, another type of product is a variable annuity with what's called a GMWB. Let's talk about what that is. I think a lot of people when they hear variable annuity, they think "expensive," they think "complicated," and that's often the case, but let's talk about this product in relation to longevity protection. What does it do for you?
Blanchett: So these products are usually both expensive and complex, but the idea is … so think about the way an immediate annuity works. You trade a sum of money for income for life. People have a hard time doing that, because what if I buy it and I die the next day. Well, with the VA+GMWB, that stands for Guaranteed Minimum Withdrawal Benefit, you … give the insurance company your money, and then they guarantee you some kind of income for life. So, then you have this contract value, and if the rate goes to zero, they keep paying you. So the positive aspect of that is you still have this benefit you can pull out if you want to you; you've also got guaranteed income for life.
Benz: So how about the cost piece, because on a surface that sounds pretty good, but overall an expensive proposition?
Blanchett: They can be incredibly expensive. You don't usually see the wide range of cost with SPIAs, for example, because they are very simple. These can be mind-numbing complex, and it's often hard to figure out, what are costs involved. Vanguard has a very low-cost product; there are other kind of no-load providers like Ameritas, and then you have the other spectrum where there are contracts that cost over 4% per year.
Benz: OK, so really the consumer has to be on his or her [toes]--beware--and do their due diligence before pulling the trigger.
So let's discuss the current environment for some of these products. I think one headwind for the fixed-type products is that they are very beholden to what their current interest rate environment is. Let's talk about how that works and why that's a risk for annuity buyers right now?
Blanchett: So, if you think about the payout rate for an immediate annuity or longevity insurance, it's based mostly on two factors. The first is the amount the company can earn, the interest they could earn on your monies over your life expectancy. So they are going to invest your monies in something, and so if interest rates are low, they can't earn as much money on their investments. The other main component is how long you are expected to live.
So, if you think about those two components, that would suggest that the immediate annuities right now are relatively expensive given the coverage, because they can't invest the money themselves, the insurance companies, and make a high rate of return. So there is a large cost right now with immediate annuities or longevity insurance because of the low-interest-rate environment.
Benz: You think it's important to point out that no matter what product type you choose, you may not end up a winner; in fact, people on average do not end up winners?
Blanchett: It's a great point, because people think about annuities, and you shouldn't expect on average to make money. Now I know that some people have bought them and they have lived for 30 or 40 or 50 years, and they have come out ahead. Other folks haven't done as well. You buy an annuity for the same reason you buy car insurance or life insurance or homeowners insurance--because you don't want the risk of outliving your resources. So the key question is, what is the cost of that insurance, and is that cost worth it to me. And the cost can vary significantly across different types of insurance.
Benz: So I guess a big question is, if I am surveying these products and knowledgeable about what each one entails, how do I figure out which is the right type of product for me, given my particular situation?
Blanchett: Honestly, my best recommendation is to talk to a fee-only financial planner that doesn't recommend them, because they can't sell you one.
Blanchett: Right now, given where rates are, I kind of like the VA+GMWBs, because they have that variable component that could actually pay off down the road, but on the flipside they are very expensive, and they are hard to understand. So you really need someone to explain them to you as the average investor to understand what you are buying and why it makes sense.
Benz: So the fee-only piece buys you someone who will look at these things at arm's length, help you evaluate the different riders and the costs, and help you make a good decision?
Blanchett: Yes, and a lot of financial planners don't like annuities, because they are expensive. … I like knowing someone has guaranteed income for life. You should never annuitized all your money, but I think it's good to have a lot of your income as guaranteed for life. Most people have Social Security, and for a lot of folks that's going to be enough, but if you are worried about outliving your resources, I don't think that the cost is worth of benefit to not buying them for a lot of people.
Benz: Okay. Well, David, thank you for this overview. It's been very helpful.
Blanchett: Thank you.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.