New Tools to Manage Longevity Risk
If you could guarantee yourself an inflation-protected stream of income for the rest of your life, would you take it? For many retirees, the answer is yes, and that is rightfully sparking new interest in deferred-income annuities (DIAs).
By combining a DIA with a TIPS ladder or more aggressive equity-centric investments, retirees can obtain inflation-protected lifetime income. But they will face important tradeoffs, as I will explain.
First, let’s look at how a DIA works. Sometimes referred to as longevity insurance, DIAs involve the purchase of a delayed income stream that begins at an advanced age and continues for life. A typical example is a 65-year-old new retiree purchasing an income stream that begins at age 85. Such an approach is attractive because the individual can use just a small portion of retirement savings for the DIA, then apply the remainder of his or her savings toward systematic withdrawals until the DIA payments begin.
DIAs are much less expensive than annuities that begin payments immediately. For example, a 65-year-old female would pay about $310,000 for lifetime payments of $20,000 annually beginning immediately, compared to about $36,000 for the same income stream beginning 20 years hence. The cost is so much lower because only about half of those purchasing such a DIA will live to collect any income, and the insurer will have 20 years to invest the premium deposit before beginning payments.
Carriers that currently offer DIAs are MetLife, the Hartford, Symmetra, and New York Life. DIAs have been available for close to a decade, but they have not been widely popular. That may be changing, however, as retirement income management draws new attention. The government has provided additional support for both DIAs and annuities in general with the recent release of proposed regulations aiming to overcome impediments to providing lifetime income options in 401(k) plans.
When selecting a DIA, considerations include finding the best pricing, assessing insurer financial strength, choosing the number of years of deferral (or opting for flexible deferral), and deciding whether to pay extra for a refund feature. A more complex issue is how to manage your clients’ investments during the deferral period until DIA payments begin.
At one extreme is a "safety-first" approach, which involves funding systematic withdrawals with laddered bonds (or TIPS), and at the other extreme is an aggressive strategy of investing heavily in stocks for their greater return potential. In the remainder of this article I'll show expected outcomes and associated risks for these two strategies, and discuss how the choice of strategy depends on a client's particular financial situation.
The systematic withdrawal baseline
I'll illustrate the alternative strategies using an example of a 65-year old female who has $500,000 of retirement savings and wants lifetime income of $20,000 per year, with annual increases for inflation. (Those familiar with research on retirement withdrawal strategies will recognize this goal as equivalent to applying the "4% rule.")