A Benefit to Boost Spending Now and Later

EDITOR'S NOTE: This article was originally published in the September 2007 issue of Kiplinger's Retirement Report. To subscribe, click here.

If you're ready to leave the workforce, you face a big decision: how to convert your assets into a steady stream of income. One of the most popular tools is the immediate annuity, where you give an insurance company a chunk of money in exchange for a promise of regular payments for the rest of your life.

But a new study has found that a relatively new type of annuity -- called longevity insurance -- may offer a bigger bang for your buck. Like an immediate annuity, you might invest a certain amount of money at age 65. But instead of receiving payments immediately, with the longevity product you don't start collecting monthly payouts for 20 years.

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If your primary concern is making sure you have money in old age, the longevity annuity is a better deal than an immediate annuity, says Jason Scott, the study's author and managing director of the Retiree Research Center at Financial Engines, a Palo Alto, Cal., company that provides investment advice. "You're worried about your portfolio running out of money in 20 or 30 years -- not next year," he says.

Of course, there's a good chance you'll never see a cent from a longevity product. Today's 65-year-old man has about a one-in-three chance of living to age 85; for women, the odds of reaching age 85 are about one-in-two. (Because women live longer, longevity products are more expensive for them.)

So, what's the appeal? Scott notes that by buying insurance against the costs of very-old age, a retiree can be liberated to spend more of his or her portfolio between ages 65 and 85. For instance, he says, a 65-year-old man with a $1 million bond portfolio would need to set aside $338,000 to provide adequate income between 85 and 100. The remaining $662,000 would be enough to provide annual income of $58,800 each year between ages 65 and 85, assuming a 2.5% real (after-inflation) return. But if the retiree buys a longevity policy for $79,000, he could boost his annual income starting at age 65 to $71,500.

Why the big bump up? Because by insuring himself against the costs of very-old age, he can now spend the $259,000 that he otherwise would have had to preserve to tap after age 85. Buying the annuity allows him to spend down the entire $921,000 -- and all its earnings -- during the two decades between 65 and 85, rather than the stunted amount available if he has to rely on his portfolio to cover potential expenses between 85 and 100.

"You're able to spend your portfolio at a higher rate because you don't have to set aside so much for your later years," Scott explains. Of course, in this scenario, at age 85 (if you make it to that age), your entire portfolio will be used up. There will be nothing left for your heirs. If it's important for you to leave money to your family, longevity insurance may not be the best option for you.

If your health or your family history makes it unlikely that you'll live past age 85, there's little point in buying the insurance, Scott concedes. You can boost annual withdrawals from your portfolio by basing them on a shorter estimated lifespan. (You can download the study, The Longevity Annuity: An Annuity for Everyone?, at http://ssrn.com/abstract=992423.)

Longevity products are offered by Metropolitan Life Insurance Co. and The Hartford Financial Services Group. It's a good idea to check with a financial planner before you buy. Prices may differ from those in the study. Also, it's possible that a portfolio allocated among stocks and bonds could generate more than the study's bond-only portfolio, diminishing the advantage of the annuity. And if you're more comfortable with guaranteed income from day one of retirement, stick with an immediate annuity.