Like an immediate income annuity, a longevity policy allows purchasers to convert a lump sum into a pension-like stream of income for life. But while an immediate annuity starts issuing payments almost instantaneously, longevity policies require policyholders to pick an income start date in the future. (Each insurer sets its own parameters, but start dates can range from one to 40 or more years from purchase.)
Why wait? When payments begin, they will be bigger than what you would get with a regular annuity. Currently, a 65-year-old man paying $100,000 for an immediate fixed annuity can get about $6,950 a year for life, according to ImmediateAnnuities.com, a website that provides free quotes from insurers. But with a longevity policy that starts issuing payments at age 85, his annual payout will be $63,990, New York Life says.
Knowing this safety net will fall into place, you might be able to withdraw a higher percentage of your savings earlier in retirement than you would otherwise, says Jason Scott, managing director of the Retiree Research Center at Financial Engines Inc., a Palo Alto, Calif., company that manages 401(k) accounts. Moreover, Mr. Scott adds, it is easier to plan to make a retirement nest egg last until these payments begin than it is to figure out how to stretch it over an uncertain lifetime.
Longevity insurance may also help those unable to obtain long-term-care insurance, although there is no guarantee that payments will coincide with long-term-care expenses, says Dan Guilbert, executive vice president at Symetra Life Insurance Co., a subsidiary of Symetra Financial Corp., of Bellevue, Wash. Symetra introduced a longevity annuity in 2008.
With defined-benefit pension plans falling by the wayside, a growing number of buyers are turning to longevity policies to serve as pension substitutes.
In September, Mike Staggs and his wife, Nancylee, both 59 years old, put about 15% of their retirement savings into Northwestern Mutual Life Insurance Co.'s Select Deferred Income Annuity, a product introduced last April that now accounts for 20% of the insurer's income annuity sales. The San Marcos, Texas, couple will start to receive their income payments in a decade, when Mr. Staggs plans to retire from his job as a salesman for a Houston manufacturer of products for cement plants.
From that point until they die, the Staggses will receive annual payments equal to 10% of their original investment, says their Dallas-based adviser Tom Weilert. That's a significantly higher level of income than the Staggses—who describe themselves as risk-averse—are likely to be able to produce from investing the same lump sum in, say, Treasury notes and then sticking to the convention of withdrawing no more than 4% annually from the proceeds.
Of course, the policies aren't without their downsides. As with most fixed annuities, you surrender your principal to the insurer. If you die before payouts begin, the insurer keeps your money.
Then there's the question of investment returns. In deciding to buy longevity insurance, the Staggses wanted no part of the stock market. But if returns are near historic norms, people willing to invest in a diversified basket of stocks and bonds rather than longevity insurance have a good chance of doing better on their own over time.
Moreover, if inflation heats up, the purchasing power of the annuity payments will be reduced. For example, over the course of a decade, a 6% annual inflation rate will cut the purchasing power of a $20,000 annual payment by almost half.
There are ways to mitigate some of these problems. If you're willing to settle for a lower income, you can ensure that your heirs will receive a lump sum or series of payments. Some insurers allow policyholders to raise their annual payments by 1% to 6% a year or more, to try to keep pace with inflation. To get this feature, a recipient must agree to either a higher premium or a lower starting point for the annual payments.
In part because payouts on annuities are near multiyear lows, advisers say it can make sense for those buying longevity insurance to borrow the "laddering" technique that many investors use with bonds and certificates of deposit. With such a strategy, the goal is to spread purchases over a number of years. That way, if interest rates rise, so will the payments received from future purchases.
If you plan to purchase a longevity policy with money from your 401(k) or IRA, be aware that you may have to start your stream of income by age 70½. That's when the Internal Revenue Service requires those with tax-deferred accounts to begin withdrawing this money—and paying income tax on it in the process. (The Treasury's proposal would provide "special relief" from this requirement if certain conditions are met.)
It is safest to stick with insurers with triple-A or double-A ratings of claims-paying ability. You can also protect your annuity investment by buying from different carriers.
In the event of an insurer's insolvency, industry-backed guaranty associations in each state provide at least $100,000 in coverage of projected annuity benefits, with many covering up to $250,000 or more. Go to www.nolhga.com for links to the association and coverage limit in your state.
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