Transferring longevity and market risk with immediate annuities

The legendary prognosticator Yogi Berra opined, “The future ain’t what it used to be.” Financial advisors and financial consumers should pay heed to Mr. Berra’s sage observation, especially when it comes to how America’s changing age demographics will likely impact their finances.

It’s also good advice for anyone who expects to receive future income based on calculations using average historical returns for investments subject to market fluctuation. Failure to proactively and simultaneously address longevity risk and market risk can jeopardize the lifetime success of a financial plan.

According to the U.S. Census Bureau, about 1 in 8 (13%) U.S. residents are age 65 or older. However, as the baby boomer generation continues to age, that ratio will shift to 1 in 5 (19%) by 2030. While at first glance, that may not seem like a large shift, check the math: it’s a 46% increase in the number of folks age 65 or older!

In February 1996, the U.S. Census Bureau projected that, by 2050, an American man’s average life expectancy would increase from 72.5 years to 79.7 years and an American woman’s average life expectancy would increase from 79.3 years to 84.3 years. However a more recent report indicates that longevity is increasing at a more rapid rate. A 2005 report by the Society of Actuaries indicates the current average life expectancy is already about 80.9 years for men and 86.6 years for women, and average life expectancy is projected to grow to 84.6 years for men and 89.6 years for woman by 2030.


While average life expectancy appears to be on the rise, using average life expectancies for planning purposes creates a potentially large problem: only one half of the lives used to calculate the average are deceased by the time the sample population actually reaches average life expectancy age. In theory, about half of those who plan to consume their assets over their average life expectancy are going to run out of money before they run out of time.

A rising number of seniors who are living longer will most certainly have an effect on the retirement benefits paid under the Social Security system. While it may be unlikely that Social Security retirement benefits will be eliminated, the Social Security Act has been amended several times since being enacted on Aug. 14, 1935. Possible changes affecting retirees could include an increase in the retirement age, higher taxation of Social Security benefits or a reduction of benefits paid under the plan.

In defined benefit pensions, the combination of pensioners outliving actuarial assumptions and plan assets underperforming investment assumptions has had a devastating effect. As a result, few public companies offer defined benefit plans to their employees anymore. Many government employees still labor under the assumption that they will receive traditional pension benefits at retirement, but given the current economies of many states and municipalities, it may be wise to discount the value of any projected pension benefits for planning purposes.

In an attempt to overcome the difficulties presented by increased longevity, some financial pundits and media often advocate that consumers simply assume more risk in their investment portfolios in an attempt to achieve higher returns. Considering the volatility experienced by many investors over the last decade, it’s baffling that many are still willing to openly embrace such strategy.

Regardless of what an investment’s expected average performance is, average performance cannot be used to model or simulate real life circumstances. If an asset has a starting value of $100, then falls in value to $50, but finally grows in value to $150, the asset’s average performance is 22.47%. But if the owner has to sell the asset for $50 to create cash flow, the fact that the asset is eventually worth $150 is meaningless to him. Similarly, when a retiree is systematically liquidating assets to provide income while market values are falling, it doesn’t matter that values eventually recover; the assets that were sold at lower values are gone.


Annuities can manage risk
Ironically, financial advisors and financial consumers embrace the concept of risk transfer throughout their working lives but largely exclude it in retirement. They use life insurance to transfer mortality risk, auto and homeowners’ insurance to transfer liability risk, and health and disability insurance to transfer morbidity risk. Financial advisors and financial consumers should also be using immediate annuities to transfer longevity and investment market risk.

When an immediate annuity is purchased, the consumer (or annuitant) is transferring longevity and market risks to an insurance company that is more efficiently equipped to manage the risks. Since insurance companies have the ability to pool longevity and market risks over a large statistical sample of annuitants, insurance companies can match the duration of their investment portfolios to coincide with the maturity of their obligations. This is an advantage unavailable to an individual investor.

In transferring longevity and market risks, the consumer is protected from the financial damage and the loss of dignity that occurs when a person has consumed all of his or her assets. They also gain a confidence and peace of mind that is lost when attempting to assume all of the risks associated with managing an investment portfolio to meet a longevity target that is impossible to accurately estimate, in an investment market that is influenced by countless factors outside of an individual’s control.

Financial advisors and financial consumers at times delude themselves that they can self-insure against longevity and market risks purely through asset allocation and portfolio rebalancing strategies. Simply put, self-insurance means no insurance, and the consequences resulting from running out of money and having no way to produce income at an advanced age are staggering.

Given the numerous ways immediate annuities can be designed to include cash refund features, period-certain payments, inflation-adjusted payments, and joint life income streams, it is possible to use one or more immediate annuities to design a plan of guaranteed income that meets many financial consumer’s desires.

As the American population continues to age, retirees may be less likely to rely on government or corporate guarantees for income during retirement. As a result, financial advisors and financial consumers should evaluate the use of immediate annuities to relieve the stress that longevity and market risks place on the long-term success of an investment portfolio.

 

James M. Hasley, CFP, CLU, ChFC, is a managing partner at Elite Financial Partners

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