The Longevity Annuity: An Annuity for Everyone?

As of 2005, U.S. individuals had an estimated $7.4 trillion invested in IRAs and employer-sponsored retirement accounts. Many retirees will thus face the difficult problem of turning a pool of assets into a stream of retirement income. Purchasing an immediate annuity is a common recommendation for retirees trying to maximize retirement spending. The vast majority of retirees, however, are unwilling to annuitize all their assets. This research demonstrates that a “longevity annuity,” which is distinct from an immediate annuity in that payouts begin late in retirement, is optimal for retirees unwilling to fully annuitize. For a typical retiree, allocating 10–15 percent of wealth to a longevity annuity creates spending benefits comparable to an allocation to an immediate annuity of 60 percent or more.As of 2005, Americans had an estimated $7.4 trillion invested in IRAs and employer-sponsored retirement accounts. Many retirees will face the difficult problem of turning a pool of assets from these accounts into a stream of retirement income. Purchasing an immediate annuity is a common recommendation, from academics and practitioners, for retirees who are trying to maximize retirement spending. The vast majority of retirees, however, are unwilling to annuitize all of their assets. Yet, many retirees may be willing to annuitize a portion of their assets if the benefit is sufficiently large. In this article, I extend the theory by answering a key question in that case: Which annuity should I buy with only a fraction of my assets? Specifically, I demonstrate that a new type of annuity, a longevity annuity, is optimal for retirees unwilling to fully annuitize.Longevity annuities are essentially immediate annuity contracts without the initial payouts. That is, a longevity annuity involves an up-front premium with payouts that begin in the future. For example, an age-85 longevity annuity can be purchased at age 65 with payouts commencing only when and if the purchaser reaches age 85.To motivate the desirability of longevity annuities, this paper begins with a fundamental question: What makes insurance valuable? Insurance is generally valuable because it lowers the cost of risk management. But not all insurance is created equal. Some insurance contracts are better able to lower the cost of risk management than others. The desirability of any given insurance contract depends critically on the likelihood of an insurance payout. For low-probability events, an insurance company can pool the risk across policyholders and offer a substantial discount to each policyholder relative to the cost of self-insurance. For high-probability events, the discount relative to self-insurance is substantially smaller.Longevity insurance follows these same basic insurance principles. For a 65-year-old retiree, little risk-pooling benefit is to be gained by insuring age-66 income. Because the majority of age-65 individuals live to age 66, insurance can provide only a small benefit relative to self-insurance for this income payment. Living to age 100, however, is a low-probability event, thus insurance can substantially reduce the cost of providing income at age 100. By focusing on later, high-value insurance payments, a longevity annuity can deliver much larger spending benefits per premium dollar than immediate annuities can deliver. For a typical retiree, allocating 10–20 percent of wealth to a longevity annuity increases guaranteed spending in retirement by 20–30 percent relative to self-insurance. If an immediate annuity were used instead, a comparable spending boost would require an allocation of 60 percent or more.Note: The views expressed herein are those of the author and not necessarily those of Financial Engines.