Fixed Index Annuities: Protecting Against the Longevity Risk
November 18, 2015 by Eric Taylor
While advances in modern medicine and healthier lifestyles are leading to longer lifespans and more time spent in retirement, these advances are creating another reality: the distinct possibility that some Americans could outlive their money.
According to the Social Security Administration, one out of every four 65-year-olds today will live past age 90, and one out of 10 will live past age 95. With the average retirement age at 63, increasing life expectancies mean retirement could last 20 or even 30 years for many clients.
Longevity risk, which is the risk of outliving retirement savings, could result in a lower standard of living for your clients and increase the likelihood that your clients’ retirement years may fall short of their expectations.
The Challenge
According to Genworth’s survey “The Future of Retirement Income,” 52 percent of consumers did not save enough money prior to retiring and 77 percent believe they have insufficient protection from the possibility of outliving their income.
Further contributing to longevity risk is the decline of traditional sources of income. In 2014, only 8 percent of all private-sector companies provided defined benefit plans, according to the U.S. Bureau of Labor Statistics.
In addition, the current replacement rate of Social Security is about 40 percent of preretirement income, a rate that the Social Security Administration projects will continue to decline.
A Solution
Some financial professionals point to a greater allocation to stocks, given current market volatility and relative liquidity, as a good option to offset longevity risk.
Stocks, however, do not have downside protection. For example, if a client needs to liquidate a portion of their holdings during a stock market decline, they might have less money available to them than expected and fewer shares remaining to make up for the loss over time. What’s more, the options that do offer downside protection — such as bank certificates of deposit and money market accounts — come with interest rates that do not keep up with inflation, resulting in the potential for a loss of purchasing power.
Fixed index annuities (FIAs), on the other hand, can help combat longevity risk by making retirement savings work harder than other traditional conservative financial products with the added ability to turn on guaranteed income for life. Certain FIAs offer strong growth potential relative to other fixed income alternatives while your client waits to start income. In addition, they offer optional guaranteed withdrawal benefit income riders (for an additional cost) that include withdrawal factors guaranteed to increase every year the client defers income. In some cases, there is flexibility in starting and stopping income withdrawals as client needs change, which is important as financial responsibilities and expenses change as the client ages.
For example, Diane, 55, is a hypothetical customer concerned about principal protection and outliving her savings. After speaking with her financial professional, she decided to use $100,000 to purchase an FIA that includes an income rider, at an additional cost.
With this FIA, her money is protected from downturns in the index. Some of the optional income riders calculate the guaranteed withdrawal income off of the contract value, eliminating the complexity of a “benefit base,” and have features such as an increasing withdrawal factor in the deferral stage. The FIA with income rider that Diane chose has these features. While she defers taking income withdrawals, her withdrawal factor is guaranteed to increase every year. At her scheduled retirement age of 65, Diane’s withdrawal factor would be 7.55 percent. This results in guaranteed income of at least $7,550 per year. What’s more, with some newer product and rider designs, any interest credit that increases her contract value would result in even more guaranteed income for life.
For comparative purposes, let’s measure this approach against a money market account insured by the Federal Deposit Insurance Corp.
According to Bankrate.com, the best-paying money market account, as of the time of this writing, is yielding 1.11 percent. Minus today’s inflation rate of 2.1 percent, this nets a return of -.09 percent. If you apply that same metric to Diane’s FIA contract, her opportunity to equal or outpace inflation during this unusually low period of inflation with interest credits linked to gains of a market-based index is substantially higher.
This will help her maintain her purchasing power over time. Her FIA also provides income for as long as she lives; even the best money market account available cannot guarantee income that will last for life.
Annuities, while not generally designed to be fully liquid until after a surrender charge period, allow for withdrawals up to a certain percentage of the contract value (often 10 percent of the contract value). So if Diane needs to make a withdrawal for an unforeseen event, she can typically do so after the first year.
In addition to the growth potential, principal protection is another important factor provided by index annuities as it pertains to protecting against longevity risk.
An index annuity’s contract value won’t fall below the original principal amount if there is a performance decline in the index to which it is linked. This means clients are receiving the same principal protection they would be provided via a money market account, but with the added benefit of growth potential (net of the rider fee) any time there is a positive change in the index.
Finally, a limited number of carriers offer renewal cap protection via a bailout provision, which gives contract holders an “out” if the carrier sets the renewal cap below its specified bailout rate. In effect, the bailout creates a renewal promise by the carrier to help ensure that renewal caps or rates are higher than the guaranteed minimum during the surrender charge period. For financial professionals and their clients, it provides a measure of confidence in the product’s future upside potential.
Longevity risk is a growing concern as life expectancies continue to increase. In response, consumers are demanding safe but growth-oriented solutions that will give them guaranteed income and protection from market declines, something index annuities are well-positioned to do.
Originally Posted at InsuranceNewsNet Magazine on October 2015 by Eric Taylor.
Categories: Industry Articles
