This is a summary of the article “Provision of Longevity Insurance Annuities” by Dale Kintzel and John A. Turner, published in the Fourth Quarter 2020 issue of the Financial Analysts Journal.
Using simulations, the authors demonstrate the need for longevity insurance annuities, which begin payment at advanced older ages. They find that such annuities can help individuals reduce their longevity risk in retirement.
What’s the Investment Issue?
Deferred annuities are one way to insure people who risk exhausting their retirement savings the longer they live. This is an increasingly important issue as life expectancies increase and most retirees move from defined benefit plans to defined contribution plans. Longevity insurance annuities begin payment at advanced older ages, such as age 82. They can be bought in advance—for example, at age 45, 55, or 65—and pay out annually until the policyholder’s death.
In this study, the authors assess the need for longevity insurance annuities under various withdrawal scenarios.
How Do the Authors Tackle the Issue?
The authors use Monte Carlo simulations to assess the risk of ruin for retirees in different circumstances, assuming they make annual withdrawals fixed in real dollars from their 401(k) account. The risk of ruin is defined as the probability that a retiree’s account balance will fall below the annual withdrawal amount.
Survival probabilities are derived using the Society of Actuaries’ Retirement Plans RP-2014 mortality table for healthy pensioners. Investment returns are based on Federal Reserve Economic Data from 1973 to 2018, encompassing monthly historical returns for three assets: a stock market index fund, a corporate bond fund, and a 10-year US Treasury bond fund. The percentage of assets allocated to stocks follows the 100-minus-age rule, with the remainder being split evenly between the two bond funds.
The authors illustrate using a starting portfolio value of $125,000, which is close to the retirement account balance of the median US household. Annual withdrawals are subtracted from the account balances in January of each year.
They run 10,000 Monte Carlo simulations of real monthly returns for retirees who begin making withdrawals at ages 62 and 70 and then assess the risk of ruin before ages 82, 85, and 90 for various levels of annual withdrawals.
They then model how longevity annuities might contribute in practice. They demonstrate how retirees can use 25% of their retirement fund ($31,250) to purchase longevity insurance and that this can be pre-funded in a lump sum at age 45, 55, or 65. Under each scenario, they model the average annuity payouts for male and female retirees. The model then combines the risk of ruin at different ages and annual annuity withdrawal amounts.
Finally, the authors compare approaches by which longevity insurance annuities can be provided. They contrast insurance provided by the private sector—through employer-provided pension plans, individual retirement accounts, and individual purchase—with government-provided insurance through social security programs.
What Are the Findings?
The authors show that there are various situations in which retirees might face a significant risk of ruin during their lifetimes and, therefore, could benefit from longevity insurance annuities. For example, an individual who makes annual withdrawals of $7,500 starting at age 62 faces a 12.88% risk of ruin before age 82 but a 65% chance of ruin before age 90. The earlier an annuity is funded and the later payouts begin, the higher the payout in relation to the premium. The result is that pre-funding annuities at an early age can lead to dramatically lower risk of ruin in retirement. A policy funded at age 45 and redeemed starting at age 85 will return a male retiree 96% of his entire premium every year he is alive from age 85, and a female retiree will receive 79% of her total premium every year. Such pre-funding mitigates the risk of ruin those without such an annuity face.
When comparing approaches for providing longevity insurance annuities, the authors note that insurance companies in the private sector will face adverse selection, because policy buyers will be disproportionately made up of individuals who expect to live longer than average. Conversely, adverse selection would not be a problem if the benefit were provided in the public sector through social security to everyone reaching the age of eligibility.
What Are the Implications for Investors and Investment Managers?
This study outlines a number of scenarios under which retirees could benefit from longevity insurance annuities. The authors assert that for many people, deferred annuities would greatly simplify the problem of managing the spend down of assets by reducing longevity risk in retirement.