Is a Longevity Annuity a Smart Choice for You?

Michael Kitces is a partner and the director of research for Pinnacle Advisory Group, and publisher of the financial planning industry blog Nerd's Eye View. You can follow him on Twitter at @MichaelKitces or connect with him on Google+.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Longevity annuities have been getting more attention in recent years. Joining me to discuss how they might fit into a portfolio is financial-planning expert Michael Kitces.

Michael, thank you so much for being here.

Michael Kitces: My pleasure. Thanks for having me back.

Benz: These qualified longevity annuity contracts have really been in the press over the past year or so. Let's talk about, first, what they are and why they have been receiving more attention of late.

Kitces: A longevity annuity is kind of an interesting beast unto itself. The industry actually has even struggled to figure out what to call these in order to describe them. The way I actually found is easiest to describe what longevity annuities are is to describe what they are not. What they are not are immediate annuities. The immediate annuity is that classic annuity transaction that literally goes back hundreds of years: I write a lump-sum check to an insurance company or a provider and, in exchange, they give me checks for life. So, in today's marketplace, a 65-year-old married couple could write a check for about $100,000 and they would get checks for life of about $500 a month for however long it is that they live. I write the check now; I start getting the monthly checks in return immediately.

Longevity annuities take that same kind of trade-off--I'm going to write $100,000 check now in exchange for payments for life--but instead of having the payments in return begin immediately, they are not going to start until later; they are deferred. So, a classic longevity annuity transaction might say, "I'm going to write a $100,000 check now as a 65-year-old couple, and I'm not going to get any checks until I turn 85; but when I do, because I put a 20-year waiting period in there, the checks are huge." In today's marketplace, we find they are about $2,600 a month--that's more than $30,000 a year. So, there's this very magnified outcome. I write a $100,000 check now and I get a payout rate of 30%, but I've got to wait 20 years just to get my first check. So, then we get this very magnified effect on the back-end. I've got to live 20 years to get my first check, but then I only have to live three more years to recover pretty much all of my principal at $30,000-plus a year. Then, I only have to live three more years to double my money, three more years to triple my money, and three more years to quadruple my money. It just grows exponentially from there.

So, that's the nature of a longevity annuity. And this magnified outcome--I don't get any growth upfront, but I get huge growth in the back-end--is from a research perspective, an amazingly efficient way to solve the retirement-income puzzle because, not to be morbid, if I pass away in the first 10 or 20 years, I probably don't have a retirement-income shortfall. If I live well into my 90s, I'm at a significant risk for a retirement-income shortfall because that's a long time to fund retirement. So, that's a fantastic time to have an investment that's paying me out 200%, 300%, or 400% upside in the later years.

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Benz: In terms of how these products have gotten into the news, the reason that they are getting more attention is that they are now a permissible option within certain types of retirement plans.

Kitces: Right. Longevity annuities originated as just a standard form of annuity. I could buy an immediate annuity where the payments begin now or I could buy this longevity annuity version where the payments begin later. Some companies in the industry call them deferred income annuities to kind of recognize that I'm going to get income on monthly payments but it's going to be deferred until the future.

Now, for people who just wanted to buy that with dollars from a checking account or a savings account or an investment account, that was pretty straightforward--write your check, get your terms, payments will begin in the future. That created a problem in retirement accounts, though, because, of course, with retirement accounts Uncle Sam wants a share and says, "Well, I don't care whether you need the income or not, when you turn 70 1/2, you have to start taking money out so that Uncle Sam gets a slice." We call those the required minimum distributions.

So, we had this conflict. Some retirees wanted to buy longevity annuities because they wanted the payouts in their later years with that big return in their 90s, and they wanted to buy it in the retirement accounts because that's where many of us keep our retirement savings. But we had this conflict: I want to buy it in my retirement account, but the checks won't begin until 85 and the IRS says I need to take money out when I'm 70 1/2. How do I get the money out when I'm not getting any checks until I'm 85? So, almost two years ago, the IRS and Treasury created these new rules for what are called qualified longevity annuity contracts, QLACs for short. And the QLAC rules simply say you're allowed to buy a longevity annuity inside of a retirement account and not get in trouble with the RMD rules even though you don't get your first check until age 85; they simply limit the dollar amount. You can't do more than $125,000 of total dollars or 25% of your account balance--whichever is less. So, we are a little bit limited on retirement accounts, but we can do it with retirement account dollars. Or you can buy as much of this as you want with taxable account dollars.

Benz: So, payouts, as you indicated, can be pretty attractive. Let's talk about how they stack up relative to other asset classes. If the person is looking at their account and saying, "Well, I could deploy my money in any number of ways," how do they make this comparison about whether the money is best deployed into one of these longevity annuities?

Kitces: Good question. Longevity annuities suffer from this thing I call the compared-to-what problem, which is whether you think these are a good or a bad deal really depends on what you would have been using as an investment instead. Again, some alternatives just clearly lose. The number-one version of a longevity annuity is simply delaying Social Security until age 70--and in fact, it really never makes sense to buy one of these until you've delayed Social Security until 71. Delaying Social Security is kind of like a longevity annuity; it's price based in 1983 interest rates and mortality tables because that was the last time we changed the Social Security system, and those are really good payout rates by today's environment.

Now, at the other end of the spectrum, if we compare this to something like a bond investment, the argument for this gets really powerful. Now, most people can't intuitively do the math: If I get a 30% payout rate but I have to wait 20 years to get it, is that actually a good deal or not? What's the value of a 30% payout rate that doesn't start for decades? When we actually run the math on this--and we've done some analysis and published some research on this--what we find is that the payout rates on these longevity annuities, if you do really well, say you live to 100, your payout rate is about 5% to 6%. In other words, you would have had to buy bonds that paid you 5% or 6% over the next 30-plus years to get an equivalent of a longevity annuity payout. Now, when we look at interest rates today, 5% or 6% actually is pretty good return--very compelling. So, if you are using this as a fixed-income substitute, longevity annuities actually look really good.

When we compare to equities, though, it's unfortunately not quite so good. When we look at long-term returns on equities, it's closer to 10%, even when we haircut the returns a little bit for being in a high-valuation environment. Over 30-plus years, even high valuation doesn't take that much off returns. And when we compound out for 30 years, we find that good old equities still look better than where longevity annuities are right now. So, we can kind of do a hierarchy here: Delaying Social Security is best, then equities look good, then longevity annuities are behind that, and then bonds are way down behind longevity annuities in the long run. So, that's how we look at stacking them up right now.

Now, the interesting effect, of course, is that all of these are dynamic. Interest rates change over time, so bonds may look a little different at some point. Because insurance companies fund longevity annuities heavily with bonds--that's how the insurance company makes sure they will have the money to pay you when the time comes--they are actually sensitive to interest rates as well, which means if interest rates go up, bonds will get more compelling. But if interest rates go up, longevity annuities will get more compelling as well. We actually think there is some possibility that if rates rise enough, longevity annuities will actually be competitive with equities, head to head, and that the future of retirement might be a blend of equities and longevity annuities. Even arguably right now, we can make the case for a blend of equities, bonds, and longevity annuities (where the longevity annuities come out of the bond portion)--all just trying to put together this combination picture of how we deal with the risk of inflation, the risk of equity volatility and sequence-of-return risk, and the danger that we just live a really long time and don't have enough money to fit that whole time horizon.

Benz: Do you think that increased competition in this space could actually be ultimately beneficial for would-be buyers?

Kitces: I've written about this a couple of times. I think, ultimately, a little more competition in this space probably would be good as well. The reality right now is, even when we look at the annuity landscape overall, there has been a lot of discussion that longevity annuities have been the fastest-growing annuity product; sales in 2015 were up, I think, more than 50% over where they've been in prior years, but that was from a very small base. Overall, longevity annuities are less than 1% of all annuity sales and, of course, annuities are only a small fraction of the total retirement marketplace.

So, unfortunately, there is just not a lot of pricing competition really there yet. So, I think we will see some counterbalancing factors in the coming years. Having competition where annuity companies want to win the business so they offer to pay out a little bit more could lift payout rates a little bit. Rising interest rates could lift payout rates a little bit. Although, ironically, if we keep getting healthier as we make more and more medical breakthroughs, that could actually bring the payout rates down because, of course, the annuity companies need to hedge against the possibility that we all live to 100. They are meant to insure the fact that a few of us might live to 100, not all of us living to 100. So, there are a lot of forces hitting longevity annuities from all directions; we'll see how it plays out on whether the payout rates really get better or how much better they get. But certainly from what we see today, they are much better than bonds for long-term retirees trying to hedge against the possibility that they live into their 90s or to 100. They're not terribly compelling compared with equities yet--although not horribly far behind either. But they still can't hold a candle to delaying Social Security.

Benz: So, the profile of a person for whom such a product would be especially appropriate would be a person with longevity on their side and they should have already looked at the Social Security maximization in delaying Social Security. Any other factors?

Kitces: Here is the driving scenario that we see: You've got to be optimistic about your health overall. Now, of course, and ironically, this actually brings longevity annuity payout rates down a little bit because the insurance companies have long since figured out that people who pick these tend not to merely be of average health, they tend to be pretty healthy. But on the flip side, that means you really probably don't want to buy one at this point unless you are part of that very healthy pool that's got family genetics on your side and you're concern that you are going to live in your 90s or 100s. So, you need good family genetics and health on your side; concern about living out to 100 and that you might not have enough money to get there; you should have already delayed Social Security until age 70 and are looking at more ways to hedge against this possibility; and I think, certainly for today's marketplace, you should have some fixed income that you can carve this out of.

Again, it's a little bit difficult to make the case for this over equities right now, but it's very easy to make the case for it over fixed income. So, if only to view it as a fixed-income diversifier, it looks really compelling to say, "Well, maybe we should take a little bit out of the bond allocation and put it over toward this longevity annuity instead." If something happens over the next 10 or 20 years, we won't end up having the money and using it; but if we live for a long time, we've got this really nice payout that looks much better than bond rates today should we happen to live that long. And basically, we manage our risk to the allocation by just not putting very much into it. I know David Blanchett here at Morningstar as well has published a bit on this and found that optimal allocations to longevity annuities might only be 10% or 15% of someone's total retirement portfolio. So, we're not going to put a huge amount of money in; we're just going to put a portion in to cover those later years in a manner that looks much better than bonds and maybe even someday it will look competitive with stocks.

Benz: Michael, it's an interesting product type. Thank you so much for being here to share your insights.

Kitces: My pleasure. I hope it helps.

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