Few adults would go without auto, home, life or health insurance. But the kind of insurance that protects against the risk of running out of money in old age is still greatly underutilized.
It's called a deferred income annuity or a longevity annuity.
Most people planning for retirement should strongly consider an income annuity, and a new Brookings Institution study out in June of 2019 confirms that.
Annuities 101: How They Work
The concept behind income annuities is simple. The buyer deposits a lump sum or series of payments with an insurer. In return, the insurer guarantees to pay you a stream of income in the future. That's why it's known as a deferred income annuity.
You can choose when your payments will begin. Most people choose lifetime payments starting at age 80 or older. Guaranteed lifetime income is a cost-effective way to insure against the risk of running out of money during very old age.
The main disadvantage is that the annuity has no liquidity. You've transferred your money to an insurance company in exchange for a guarantee of future income. People who can't afford to tie up any of their money shouldn't buy a deferred income annuity.
Why Consumers Aren't Buying
Given that traditional company pensions have largely gone away, there should be great demand for income annuities, Martin Neil Baily of Brookings and Benjamin Harris of the Kellogg School of Management write in their new study. But there isn't, for a number of reasons.
People overestimate their ability to invest money wisely.
They're also concerned that if they don't live long enough, the annuity won't be worth the cost. But that's a wrong-headed view, because it's the insurance that's the most valuable aspect of the annuity, according to Baily and Harris. The value is in the stability and guarantee of lifetime income offered by the product. If your house never burns down, you wouldn't think that you wasted money on homeowners insurance. A lifetime income annuity insures us for the possibility of a longer-than-average lifespan.
And the topic is confusing to consumers, in part because of the terminology. Annuities include both income annuities as well as fixed, indexed and variable annuities that are primarily savings or investment vehicles, the study authors point out.
What Annuities Do Well
Why do deferred income annuities work so well? Income deferral is a key part of the equation. The insurer invests your money so it grows until you begin receiving income. For instance, if you buy an annuity at age 55 and don't start income payments until 85, you reap the advantage of 30 years of compounded growth without current taxes.
The longer you delay taking payments and the older you are when you start taking them, the greater the monthly payout.
Second, buyers who do not live to an advanced old age subsidize those who do. Such risk-sharing is how all insurance works, whether it's home, auto or longevity insurance.
How They Fit into a Retirement Plan
A deferred income annuity provides unique flexibility in retirement planning. Suppose you plan to retire at 65. You can use part of your money to buy a deferred income annuity that will provide lifetime income starting at 85, for example. Then, with the balance of your retirement money, you only need to create an income plan that gets you from 65 to 85 instead of indefinitely.
You don't have to deal with the uncertainty of trying to make your money last for your entire lifetime.
The Brookings study makes a similar point. An income annuity can substitute for bonds in a portfolio. For instance, suppose a couple's allocation is 60% equities and 40% bonds. The couple could safely sell all their bonds and use the proceeds to buy an income annuity.
Holding an annuity provides stability in a retirement portfolio ... making it unnecessary to hold bonds, or hold the same amount in bonds.
Also, since you know you'll have assured lifetime income later on, you can feel less constrained about spending money in the early years of your retirement.
If you're married, you and your spouse can each buy individual longevity annuities. Or you can purchase a joint payout version, where payments are guaranteed as long as either spouse is living.
The Risk of Dying Before You Break Even
What happens if you die before you start receiving payments or only after a few years, when the total amount of payments received is less than the original deposit? To deal with that risk, most insurers offer a return-of-premium option that guarantees your beneficiaries will receive the original deposit premium.
This is a popular option, but it does reduce the payout amount slightly when compared to the payout amount without the return-of-premium guarantee.
If you don't have a spouse or anyone else you want to leave money to, you won't need this option.
The Brookings report, "Can Annuities Become a Bigger Contributor to Retirement Security," can be downloaded at https://www.brookings.edu/research/can-annuities-become-a-bigger-contributor-to-retirement-security/.
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Copyright 2019 The Kiplinger Washington Editors