Insure Against Longevity Risk with Immediate Annuities

Are immediate annuities about to finally get some respect?

Just to be clear: I'm talking about the plain vanilla, single premium income annuity (SPIA), not the more complex, expensive variable type of annuities. The SPIA has never played a big role in the financial landscape of retirement products; one estimate suggests they account for about two percent of current household income for retirees.

But the SPIA can be a useful way to insure your clients against longevity risk—the risk of outliving their money. A retiree makes a single payment to an insurance company, which in turn promises to send a regular check from a date certain. In most cases, the payments continue for life.

Sales were gaining momentum before the 2008 financial crisis and meltdown, more than doubling to a peak of $7.9 billion in 2008 according to LIMRA, the industry research and consulting group (See Chart A ). Sales have been essentially flat since then; the financial crisis of 2008 and 2009 generated consumer concern about the long-term stability of insurance companies, and interest rates—which drive the pricing and yield of income annuities—also have dampened sales, given current ultra-low rates.

But there are signs that the SPIA is poised to play a larger role in the retirement landscape. Insurance companies are making headway establishing active third-party distribution channels; for example, New York Life Insurance Co. reports that first quarter income annuity sales jumped 45 percent on the strength of its third-party distribution. Fidelity Investments, which offers SPIAs from New York Life and four other insurance companies, had its best first quarter ever for SPIA sales, up 25 percent from the fourth quarter last year.

According to LIMRA, the industry's average annuity premium is $107,000, and the average buyer age is 73.

“We think there is a customer need for sources of income in retirement” says Brett Wollam, senior vice president of marketing at Fidelity. “Twenty five years ago, Social Security and defined benefit pensions supplied more than half of retirees' income, but that number has been shrinking. Retirees are increasingly responsible for generating income from own assets, and SPIAs can be a very efficient way to generate a pension-like solution from retirement savings.”

“I'm hearing more interest from larger distribution firms,” adds Joe Montminy, assistant vice president of annuity research for LIMRA. “There is more talk now about how immediate annuities can help retirees cover basic living expenses.”

The insurance industry's pitch: While retirees shouldn't annuitize all of their assets, income annuities offer unique qualities as an asset class when mixed into a broader portfolio of stocks and bonds. Those include high cash flow uncorrelated with equities or bonds, and alpha in the form of mortality credits, which are unique to insurance products.

An income annuity offers an interesting way to insure that living expenses can be met in retirement. First, estimate total monthly expenses, and subtract expected Social Security and any other guaranteed income source, such as a defined benefit pension. The gap amount is what you could consider filling with an income annuity.

That argument makes sense to Harold Evensky, president of Evensky & Katz Wealth Management. “I think income annuities will be one of the single most important investment products over the coming decade. Most products can only offer dividends, interest and capital gains, but an annuity has that fourth component, mortality return. The risk is that you die 'early' and made a bad deal – but you're dead, so you don't care! Those who live on get the extra gravy. Since most people are approaching retirement without enough money, this will be one of the best options for not running out.”

The question of yield looms large in the debate over the value of income annuities. On one hand, the mortality credits allow an SPIA to yield much more than a certificate of deposit. At the same time, low rates also depress what insurance companies can earn, which cuts into SPIA payouts. Annual payouts would jump anywhere from 8.5 percent to 26 percent on a typical $100,000 annuity if rates jumped a few hundred basis points. (See chart B) The payouts don't fluctuate in a straight line with interest rates, since they also are affected by principal and mortality credits.

Still, Evensky isn't putting his clients into income annuities right now because of current low rates—and because the mortality benefit gets better as his clients age. “We don't think there is much risk in waiting,” he says. “If you are 70, I'd wait until 72 or 73. I would rather just stay invested in bonds and delay buying the annuity until the fixed income market gets back to a more historical norm.”

Of course, objections from financial advisors and other potential third-party channels aren't limited to interest rates. The insurance industry also has been working to address several other key issues and concerns often raised by financial advisors, including:

Lack of flexibility and liquidity. The concern here is that once clients purchase an income annuity, the money is gone—there's no way to access funds in a pinch. But most SPIA customers now opt for contracts guaranteed for a certain period or with refund options that give them re-payments of a substantial portion of the original premium. And even SPIA advocates recommend against annuitizing all retirement assets. “Most research suggests anywhere from 20 percent to 50 percent,” says Evensky.

Lack of transparency in shopping. While it's true that there's no single online marketplace offering complete transparency for comparison shopping, it's possible to line up offerings via several online sites, such as Immediateannuities.com or Cannex. And the most simple way to compare is by lining up premiums and payouts for like products. “At the end of the day, if I want to receive a certain amount of payment, I can go to the various companies and simply ask how much I can get if I pay a $100,000 premium,” says Montminy.”

Lack of credit/compensation to the adviser. It's a simple fact that assets spent on an SPIA no longer show up on customer statements as assets under management. “If I'm a broker and I sell someone a mutual fund, it shows up on the statement,” says Matt Grove, a vice president at New York Life. “I get credit for it and my compensation is dependent on how much I have under management. The industry needs a way to change that for annuities.”

Indeed, an industry initiative is underway under the auspices of the Retirement Income Industry Association to find new ways to measure the value of SPIA cash flow to retirees so that the value can be reflected on consolidated statements.

Safety. Picking an annuity provider means picking a partner for life, so concerns about financial stability are well-placed. And while rating agency reputations have been tarnished by their role related to derivatives in the 2008 financial crisis, their insurance ratings remain useful. “Are their rankings absolutely accurate in every case? No one knows,” says Brett Hammond, a managing director and senior economist for TIAA-CREF. “But relative to one another the insurance ratings are valuable. And, they got in trouble over derivatives, not insurance.”

Still worried? Consider diversifying clients' annuity investments among more than one insurance carrier.

Mark Miller is a journalist and author who writes about trends in retirement and aging. He has a special focus on how the baby boomer generation is revising its approach to money, careers and lifestyle after age 50.

Mark edits and publishesRetirementRevised.com, featured as one of the best retirement planning sites on the web in the May 2010 issue ofMoney Magazine. He writesRetire Smart, a syndicated weekly newspaper column and also contributes weekly toReuters.com. He is the author ofThe Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living(John Wiley & Sons, 2010).

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