It’s a dirty trick of modern life: escaping disease and accident to live long — only to run out of money before the end.
With the withering of old-fashioned pensions combined with longer lifetimes and baby boomers flooding into retirement, the insurance industry is churning out a raft of new, deferred-income annuity products to provide guaranteed income later in life for a big payment upfront or over time. And new government rules allow investors to buy these products with money built up in tax-favored accounts, such as IRAs and a 401(k).
DIAs seek to overcome drawbacks in “longevity insurance,” which has been around for decades without catching on.
Along with their cousins, immediate-income annuities, which start smaller payouts immediately after purchase, DIAs can provide dependable retirement income for life.
“Go back a generation or two. Did anybody not like having a pension?” says Douglas Dubitsky, vice president of retirement solutions at The Guardian Life Insurance Company of America. “We are saying, ‘Well, you can create that yourself.'”
DIAs “are a good thing,” says Anthony Webb, senior research economist at the Center for Retirement Research at Boston College. “They enable households to insure [against] the risk of living exceptionally long.”
DIA sales are up. LIMRA International, the insurance trade group, says DIA sales reached $2.7 billion in 2014, up from about $1 billion in 2012. That’s still a minuscule share of the multi-trillion-dollar financial services market, but many experts expect sales to continue growing as consumers catch on to the new offerings.
The old-fashioned longevity policy, which is still available as a plain-vanilla DIA, is simple. For example, you could spend $100,000 to buy a policy at 65, and 20 years later start receiving an income as high as $50,000 to $60,000 a year. The high payout is possible because the insurer has that 20-year “deferral period” to grow the initial $100,000 before payouts begin, and because many policyholders will die before they receive much income, if any. Once spent, the premium is gone for good.
Old-style longevity insurance never really caught on, largely because consumers didn’t like giving up that big upfront payment for an income stream they might never receive.
In the past few years, insurers have addressed these concerns by offering optional features to allow the income to start earlier — at 65 in many cases. With add-on features, the income stream, once it begins, will rise with inflation. Other features allow joint coverage for a couple, and some return the premium to survivors if the policyholder dies before payouts start, or before income received equals the initial premium. Providers say many people are purchasing DIAs in their 40s or 50s, with payouts to begin in their 60s or 70s rather than 80 or 85.
“We have a lot of clients who think of it as a health care coverage possibility” for old age, says Liz Forget, executive vice president of MetLife Retail Retirement & Wealth Solutions.
Add-ons, of course, come at a price: a smaller payout. One firm, for example, offers a 64-year-old man $55,584 a year at age 85 for a $100,000 premium. Add a feature to return the premium to heirs if the policyholder dies early, and the payout falls to $36,228.
Among the add-ons, premium return has proved the most appealing to purchasers, says Chris Blunt, president of the investments group at New York Life Insurance Co. Inflation protection, which can reduce the payout substantially, has less appeal, being adopted by only about 10 percent of policyholders.
That shows many consumers have things backward, Webb says. “Inflation protection is expensive but probably worth it. Return of premium is definitely not worth it.”
Annuities generally have fees associated with them that make them more expensive than comparable mutual funds or [exchange-traded funds], and this negates any advantage in many cases.
That’s because the whole idea is to insure against the risk of living a long time. If you die soon after buying a policy, you won’t face that risk, but live a long time and inflation can chew up the buying power of your DIA payout.
DIAs have their critics, too. DIA critics typically worry that policies are hard to understand and that not enough policyholders will live long enough to make them pay off. David Weinbaum, associate professor of finance at Syracuse University, warns of costs embedded in DIA-payout calculations.
“Annuities generally have fees associated with them that make them more expensive than comparable mutual funds or [exchange-traded funds], and this negates any advantage in many cases,” he says. “In other words, they are just too expensive for what they are, and most investors would be better served in traditional low-cost index funds. I would recommend that most people not invest in annuities at all.”
Experts who do recommend DIAs generally say a purchase shouldn’t exceed 10 to 30 percent of one’s retirement assets.
In July 2014, the U.S. Treasury department issued new rules permitting DIA purchases with IRA and 401(k) assets, in a “qualified longevity annuity contract,” or QLAC. This allows investors to tap what for many is the largest or only source of retirement funds. And the rules also allow the policyholder to wait until age 85 to begin taking required minimum distributions that IRAs and a 401(k) normally require after age 70½. The maximum QLAC purchase is $125,000, or 25 percent of IRA and 401(k) assets, whichever is smaller. (Note that if your 401(k) does not offer a DIA, you would have to first transfer the funds to a rollover IRA, which cannot be done until you have left the employer.)
These new rules are gradually being reflected in product offerings. “Advisers are very interested,” Forget says.
While a DIA can be a useful tool, experts say that these days, some potential customers are holding off in hopes that higher interest rates over the next few years will make DIA payouts more generous.
Blunt says it’s true that premium pools largely hold interest-paying securities likecorporate bonds. The more the insurer earns on the pool, the more likely the firm will offer a larger payout for a given premium. “If you had a sense that rates were going to skyrocket in the short term, then you are better off waiting,” Blunt says.
But he and other experts argue that what would be gained from a modest increase in interest rates could be more than offset by the payout cut from shortening the deferral period by waiting to buy.
“Most of the time, the people who have been waiting [to purchase a DIA] got crushed in the last six or seven years,” Blunt says. Some DIAs offer a recalculation option or dividend payment to counter the effect of rising rates. And Dubitsky suggests buyers make several DIA purchases over time to improve odds of benefiting from higher rates later.
For those who live long enough, a DIA can be a good investment, as the payout relative to the premium far exceeds what can reasonably be expected from bonds, or even stocks. It would take a double-digit investment return for a $100,000 nest egg to grow enough to spin off $50,000 a year after 20 years.
A DIA purchase should be considered carefully, as payouts and other terms can vary considerably between providers. Many major life insurers offer DIAs. Online services like WebAnnuities Insurance Agency provide quotes, and financial services firms like Vanguard and Fidelity offer plans from multiple insurers. But before buying, it may be worthwhile to talk to a trusted insurance broker who can evaluate products from a variety of providers.