Here’s why, even though it’s not available in most countries
There are two sources of financial risk in providing for Life Two (that is, life after full-time work). One is that you don’t know how long you’ll live. The other is that you don’t know how large a return your financial capital will earn. Together these form a huge problem. (I’ll forgo the opportunity to quote Nobel Prize Winner Bill Sharpe yet again on the problem.)
In this blog post, I’ll discuss the more significant of the two aspects of the financial problem (uncertain lifespan), and show why, for many if not most people, longevity insurance is a valuable solution.
This is prompted by a comment on Post #151 made by Dallas Salisbury, the Founder and now-retired CEO of the (US) Employee Benefit Research Institute, whom I served happily for many years on the Board and as Chair of the Research Committee.
In Post #144 I explained why, as you age, and if you’re in at least average health, longevity uncertainty starts to create uncertainty in the amount needed to finance your future consumption that is greater than the uncertainty arising from a high equity content in your investment portfolio. In fact, for a male aged at least 75 or a female aged at least 80, financial risk from uncertain longevity exceeds that from being 100% invested in equities. I said, in that post:
“Most of us at that age would find that amount of equity risk intolerable and frightening. That implies that, by that age, we should definitely hedge our longevity risk. (Remember, I’m talking about people in at least average health, and who need some growth element in their investment returns in order to meet their lifetime needs and wants.)”
Here’s another way to think about it.
Suppose you’re in that position: specifically, a high enough age, in at least average health, and not enough capital to fund your future desired consumption with certainty if you live to the end of the longevity table. And suppose you haven’t hedged your longevity risk. Then, no matter what the equity exposure content in your investment portfolio, it’s like adding an additional 100% (or more) in equities. If you have, let’s say, 30% in equities in your retirement portfolio and haven’t hedged your longevity risk, it’s like having more than 130% equities in your portfolio. Yes, you have a leveraged position, to use the jargon. I’ll bet you never thought of it that way! In fact, only by hedging your longevity financial risk will your effective equity exposure drop back to 30%.
Which leads to the obvious question: how can you hedge your longevity financial risk?
Let’s start at the start, from first principles. What exactly is your longevity financial risk?
It’s the financial risk that arises from your living a very long life. Sure, most of us (in at least average health – I’ll stop saying this from now on, though it’s always implied) would love to live a long life. Emotionally it’s very desirable. But I’m not talking about emotion here, I’m talking about finance. And from a financial perspective, the longer we live, the riskier a financial proposition it becomes, because the chance that we’ll run out of money increases as we live longer. Hedging the risk means taking financial action that reduces or eliminates that financial possibility.
What sort of action might that be? Well, quite simply, buying a guarantee that, if we live past some specified advanced age, someone else will start to pay us money, from that point onwards, for as long as we live. If we can find that sort of guarantee, then longevity is no longer a financial risk. (Or, of course, we can buy a guarantee for some amount of regular future payments smaller than is necessary for our full desired standard of living, in which case we’ve reduced the risk rather than eliminated it.)
Insurance companies used to sell this kind of policy in many countries. These days (as I understand it – I do hope some of you will bring it to my attention if I’m wrong) they’re extremely difficult to find outside the US and Australia, and even in the US only a few companies offer this kind of “longevity insurance.” (By the way, they’re sometimes also known as “deferred annuities” or “advanced life deferred annuities.”)
How do these policies work?
Very simply. You specify an advanced age in the future (typically 85), and if you survive to that age, payments to you commence and continue as long as you live. In exchange, you pay a premium up front. And if you don’t survive to that advanced age? Then you get nothing. (No, you don’t get your premium back. I’ll tell you why, later.)
Think of it as the opposite of term insurance, which many of us carried while we were working, because then the financial risk (for the family) was that we might pass away unexpectedly early and the family wouldn’t have our future earnings available for support. Hedging that risk meant buying a policy that paid a lump sum on passing away before some pre-specified age (typically 65). And if we survived to that age? Then we got nothing.
In fact most types of insurance work that way, like home insurance, for example. The premiums simply hedge the risk, and there’s no payout if the risk doesn’t happen. That’s what keeps the premiums low and affordable – a much lower cost than self-insurance, which implies that you save in advance to be able to pay for the full cost yourself if the insured event occurs – a ridiculous amount. Imagine having to save enough to replace your home if it burns down, just on the off chance that it does! Far easier to pay the insurance premiums, and not a problem if you don’t collect on the insurance.
Notice that the home insurance premium is small only because the event is unlikely to occur. What does that mean, for longevity insurance? It means picking an advanced age that you’re unlikely to survive to. Really, therefore, the advanced age ought to be much higher than your expected survival age; so for most of us it should be well above 85. But insurance companies don’t like writing policies that are deferred beyond age 85; so the premium is much higher than a pure hedging policy should cost. Too bad, but probably still a lot better than being permanently 130% invested in equities.
What about an immediate lifetime income (a.k.a. “immediate annuity,” in the jargon), starting now rather than from survival to age 85? Doesn’t that hedge the longevity risk?
Sure, it does that, because it will pay if you survive beyond age 85. But that’s hedging much more than the risk you want to hedge! The cost of living up to an average survival age (a.k.a. “life expectancy,” in the jargon) isn’t a risk so much as something you should plan for. Why pay to hedge something you expect to happen? For example, suppose you need $1,000 next month. What you do is set aside $1,000 so that it’s available next month. You plan for it. You don’t take out an insurance policy that says, “If you survive until next month we’ll pay you $1,000.” That’s over-insurance. So too, for most of us, buying an immediate lifetime income before our expected survival age is over-insurance.
If you’re really nerdy, check out this technical explanation of the difference between immediate and deferred lifetime income contracts.
What about adding a feature that pays you your premium back if you should pass before the specified advanced age? Probably a bad idea for most people. Here’s why.
Let’s take a simple case where the advanced age is one for which you have a 50/50 chance of reaching it. Ignore interest rates (and right now they’re close enough to zero for that to be close to the truth).
In that case, the premium is expected to be returned half the time. Which in turn means that only half of the aggregate premiums for a group of people like you will be available to finance the lifetime income. Which in turn means that the lifetime income they’ll be offered is only half of what it would be to another group of people who opt for “no return” on early passing.
In other words, you’re sacrificing a large amount of post-advanced-age income (in this example, half) in order to get a pre-advanced-age death benefit.
For most people, that’s a terrible trade-off. It means you’re making a huge personal post-advanced-age sacrifice in order to give a benefit to your heirs.
What about inflation? I don’t know of any insurance companies in the US that promise to have their lifetime payments increase with inflation, though I understand this feature is available in Australia. (Once again, please let me know if I’m wrong.) But inflation between purchase and the advanced age is something you can take into account. There’s no way to know in advance how much that inflation might be. But you can make an estimate (perhaps 2% a year, but what do I know?) and specify a starting lifetime income from that advanced age that is more than the amount you need today by a factor that reflects your estimate of cumulative inflation.
Once the payments start, if there’s no further inflation adjustment, remember that you probably don’t need a full inflation adjustment anyway. This comes from Dr David Blanchett’s research that suggests that most retirees can get by just fine on an adjustment of 1% a year less than inflation.
Dallas adds a caution, though, in connection with the purchase of longevity insurance from an insurance company. It’s the future solvency of the insurance company, or (if the policy itself is reinsured) of the relevant reinsurance company: as Dallas expresses it, “the ultimate underwriter.” His own experience is expressed this way: “I add [this] because of the degree of ownership structure and change of the two name carriers from whom we purchased our ‘longevity’ annuities a bit over two decades ago.”
Is there a way to get this longevity risk hedge other than through an insurance company? For example, through some other longevity-pooling resource? Not that I’m aware of. (Again, let me know if there is such a resource.) The few longevity pools that exist (I’ve featured two of them, in Australia and Canada, in recent blog posts) are in their infancy and want to get up to speed before they might expand to accommodate variants such as longevity insurance.
OK, if you’ve hedged your longevity financial risk, that should clear your mind and let you focus the rest of your assets (the vast bulk of which still remain, after you’ve paid the premium for the hedge) to supporting your lifestyle between today and the selected advanced age. That’s a much simpler task (at least for professionals, if not for the average retiree). It involves estimating your tolerance for lifestyle risk as you seek growth, but the aspect of the problem with the biggest impact on financial uncertainty – your uncertain longevity – is no longer a factor, because the period to the selected advanced age is a fixed period. And dealing with this problem has the benefit, relative to buying an insured immediate lifetime income, that it permits you to seek equity-type growth in this period.
All of which should give you much more peace of mind.
Now you know all about longevity insurance: why it’s valuable, how it works, and some features (selection of the advanced commencement age, return of premium and inflation). If it’s available and you’re in at least average health, you might want to consider making it part of your portfolio and your life financial plan.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.