One of the hardest parts of managing a retirement is the uncertainty of life -- the mystery of betting how long a client will live and draw from his or her savings.

An investor doesn’t want to deplete assets while alive, but setting aside too much for too many years could mean that the retiree unnecessarily scrimps for a future that never happens.

The typical approach is to invest in a diversified portfolio, spend conservatively and make adjustments as necessary. But an alternative is to actually buy longevity insurance in the form of a lifetime annuity.

This could be done by purchasing a single premium immediate annuity at retirement. In practice, retirees rarely want to lock up so much of their capital.

Retirees use annuities so rarely that economists have dubbed their choice the annuity puzzle.

One option: A longevity annuity. This form of single premium deferred annuity still provides payments for life but with payouts from the longevity annuity company not beginning until the distant future (for example, at age 85).

The upshot is that the longevity annuity significantly reduces how much capital must be committed to securing the longevity insurance guarantee; even as the deferred starting date can delay required minimum distributions obligations if purchased as a qualified longevity annuity contract inside a retirement account.

Despite low interest rates, a current longevity annuity can be an appealing alternative to the expected returns of a fixed-income portfolio.

In fact, if longevity insurance rates rise just a bit more, they may become competitive with long-term equity returns, thanks to the benefit of mortality credits. That means that eventually, an allocation to a longevity annuity bucket may become standard in retirement income planning, as long as life expectancies don’t grow so much that the longevity annuity rates drop.

UNKNOWN HORIZON
Clients who will live in retirement for just 10 years can spend far more than those who may be retired for 30 years or more. The latter client may need a larger allocation to growth investments to keep up with the pernicious impact of inflation compounded for decades.

Yet without knowing the time horizon, it is impossible to know whether spending should be higher or lower and whether the portfolio can be more conservatively invested or should be somewhat more aggressive.

One approach to handling the situation is simply to put most or all of one’s retirement funds into an immediate annuity, which eliminates the time horizon problem for the retiree by receiving guaranteed payments for life from the insurance company.

Technically, this simply shifts the unknown time horizon from the individual to the insurance company. But the good news is that thanks to the law of large numbers, the insurance company can predict the time horizon for large groups of people with a relatively high degree of accuracy, far more than one retiree can for an individual account.

Despite its simple elegance, virtually no retirees annuitize a significant portion -- much less all -- of retirement wealth.

One study found that immediate annuities would leave most retirees ill prepared for a difficult health event.

The exception are those retirees with so much money that they don’t need the annuity anyway.

Some theorize that retirees prefer liquidity than what an immediate annuity offers. Others suggest that the reason rests in the low payouts.

Whatever the reason, retirees who could have sold their planning puzzle by depending heavily on annuities don’t.

INSURANCE FOR THE LONG HAUL
Longevity insurance, also known as a longevity annuity or an advanced life deferred annuity, is a form of deferred annuity contract designed to provide payments for life but with payments that don’t begin until the distant future. Although a single premium immediate annuity purchased at age 65 would provide lifetime income right then, the longevity annuity would take the same lump sum up front at 65, paying years from that point, perhaps in two decades.

The benefit of using longevity insurance is that it helps to solve the unknown time-horizon problem.

Imagine a 65-year-old couple that purchases a longevity annuity that will begin to make significant payments at age 85 to cover their expenses (inflation-adjusted) later in life. This couple’s retirement investment puzzle has been greatly simplified: They need to cover the fixed time horizon for the next 20 years because the longevity annuity will take care of most expenses thereafter if they live.

From that point forward, the longevity annuity covers everything, regardless of how long the retiree lives. In essence, the longevity annuity is providing long-term insurance against the retirement portfolio and creates an end point when the annuity payments begin.

Let’s assume this 65-year-old couple has $1 million and wants to spend $30,000 a year from their portfolio (adjusted for inflation) for the rest of their lives to supplement available Social Security income.

At 3% inflation, $30,000 a year will become $54,183 a year in 20 years when both are 85. Based on current pricing for inflation-adjusted payments, with a joint survivorship payout that continues as long as either one is alive, and a cash refund guarantee, this couple can buy a longevity annuity at $4,515.28 for a longevity annuity cost of about $249,000.

This purchase will leave the remaining $751,000 of the portfolio available to cover the next 20 years.

Instead of trying to invest $1 million for a $30,000 a year inflation-adjusted income for an unknown time horizon, the couple can invest $751,000 for a $30,000 a year inflation-adjusted income for exactly 20 years, secure in knowing that all payments beyond that point will be covered by the longevity annuity and backed by the longevity insurance company.

CLIMBING TIPS LADDER
Once a longevity insurance plan ensures that the later years are covered, the initial 20-year time period of a retirement portfolio could then be covered with a diversified portfolio.

One tactic is to use something like a ladder of TIPS bonds, or Treasury inflation-protected securities. They provide the exact amount of inflation-adjusted income for each of the 20 years, securing the couple’s lifetime income.

It would take about $554,000 to buy a ladder of TIPS to cover the payments for the next 20 years, leaving almost $197,000 left over as well. And whether the husband and wife live to 85, 95 or longer, they will have inflation-adjusted income for life because the longevity annuity payouts are made in the later years.

Of course, the 65-year-old couple could have purchased a single premium immediate annuity with inflation-adjusted payments to cover their lifetime guaranteed income goal as well, starting at 65 when they retired.

The purchase of an immediate annuity -- with inflation-adjusting, joint survivorship payments, with a cash refund guarantee -- would require about $772,000 of their capital, leaving just $228,000 for emergencies and contingencies. That is similar to the $197,000 left over from the longevity annuity scenario.

Remember that the $554,000 in TIPS bonds would still be a liquid portfolio that could be adjusted if needed.

Although it may be appealing to use the longevity annuity in this context, as it obtains to similar longevity guarantees but at a lower upfront cost, it is worth noting that the total cost in required dollars is similar. This shouldn’t be surprising because if someone is buying a TIPS portfolio plus an inflation-adjusted longevity annuity or an inflation-adjusted immediate annuity to cover the same time period, both the investor and the insurance company are ultimately investing in the same capital markets for the same time horizon and the same available bond yields.

The only difference is the liquidity of the capital, which arguably would be more appealing in the longevity annuity scenario over the single premium immediate annuity — similar income, similar costs, and more liquidity in the meantime.

MEASURING THE LONG HAUL
When longevity insurance covers retirement spending for those who live to an advanced age, the portfolio design process is greatly simplified. The package needs to cover the finite time period from retirement until the payments begin from the longevity annuity.

This 20-year time horizon would likely be covered by a rather bond-heavy portfolio, given how much spending must be supported in the near- and intermediate-term years.

In turn, this means that the longevity annuity is likely to replace primary equities in the portfolio.

Any investor in a simple diversified portfolio could choose to segment a portfolio into two buckets: one to cover the next 20 years and one to cover all retirement expenses beyond that point. Then it is just a question of whether the later years’ bucket is filled with income from equities or funded with the backing of a longevity insurance company.

An assessment of whether a longevity annuity fits in a retirement portfolios means comparing the long-term economic value -- the internal rate of return -- that can be produced by equities, versus ongoing cash flows from a longevity annuity.

Based on the longevity annuity quote earlier -- with a payment for a married couple of $4,515.28 a month -- the payout will equal the equivalent of a 5.3% internal rate of return if at least one member of the couple lives to 100 (and assuming 3% inflation). To produce equal-or-better cash flows from equities, a long-term equity portfolio must produce a comparable long-term rate of return.

When compared with actual historical returns, suddenly the longevity annuity begins to look somewhat less appealing. The graphic shows the rolling 20-year and 35-year total return for equities over nearly 150 years (based on available data from Shiller).

There have been just a few times when equities failed to generate the required 5.3% hurdle rate to beat a longevity annuity, and equities have always generated enough return over a 35-year time period to beat the cash-on-cash payouts from a longevity annuity and still have money left over.

At current rates, a $100,000 deposit for a 65-year-old couple would pay $2,255.02 a month starting at age 85, with a cash refund guarantee if the couple dies before all principal has been returned. Yet as the results show, even in the worst-case scenario, the equity portfolio doesn’t run out of money by making the exact same payments as the longevity annuity.

In fact, the worst-case scenario still has nearly all the starting principal left over.

In nearly half the scenarios, the retiree with equities covers all the payments that a longevity annuity would have provided and has more than 10 times their starting $100,000 principal left over as well. In some cases, starting principal is multiplied by as much as 50 times.

In most retirement scenarios, the real challenge isn’t getting sufficient returns to pay for retirement with growth in the later years. It is generating enough of a return to fuel the first half of retirement without using all the available assets.

The time horizon is long enough that an equity-centric portfolio can fund long-term spending needed in later retirement years without using a longevity annuity. Sequence of return risk isn’t an issue for a retiree who is already committed to not touch this portion of funds for 20 years.

This is also an indicator of why research on a rising equity glide path in retirement may work, as well.

In the few scenarios where equity returns are relatively poor early on, spending disproportionately from fixed income in the early years and allowing equities to grow -- which indirectly shifts the overall portfolio allocation to an increasing equity exposure -- actually helps to facilitate long-term success by allowing equities time to generate the needed returns for later retirement.

PRICE OF PAYOUTS
Notwithstanding the implied dominance of equities over a longevity annuity in the long run -- at least at today’s payout rates -- it is notable that for those who are going to invest purely in fixed income for retirement (e.g., bonds and CDs but not equities), using longevity insurance is still far superior to a fixed-income portfolio in the long run.

The primary reason for this is that while a bond portfolio can provide principal and interest payments over time, a longevity annuity provides principal, interest and mortality credits attributable to all those who didn’t survive as long.

In other words, not only does longevity insurance eliminate the time horizon problem for those who live a very long time, but it gives outsized payments to those who are the survivors, those who receive allocates of principal and interest from the share of those who died earlier.

It is also worth noting again that the distinction isn’t because the longevity annuity company is a super investor but simply because the company can buy the same bonds as the investor and then stacks mortality credits on top. In addition, from the perspective of time horizon, the longevity annuity is even more superior here.

A 30-year laddered bond portfolio runs out in the year after, while a longevity annuity continues to pay, even for those few who happen to live far beyond. In the long run, the longevity annuity provides both a superior internal rate of return for those who live a long life, and the return improves for those who keep living.

Ultimately, the benefit of buying longevity insurance in the form of a longevity annuity depends heavily on the other options. Weighed against an equity portfolio, the longevity annuity is still inferior, given today’s payout rates.

Equities so dominate the value of a longevity annuity that it doesn’t pay to use a qualified longevity annuity contract instead of an individual retirement account to defer an RMD obligation if it means forgoing access to equity returns.

Yet, relative to fixed-income returns, the longevity annuity dominates, both in terms of returns and the management of the unknown retirement time horizon. In such cases, the potential of a QLAC to defer RMD obligations is just an added bonus.

If a longevity annuity will be used to replace a fixed-income investment, it is better to do so with available dollars in a retirement account such as a QLAC.

This form of single-premium deferred annuity provides guaranteed payments for life, similar to a single premium immediate annuity. The fact that longevity annuity payments occur for a limited number means the retiree can commit far less in portfolio assets to get the guarantee.

This doesn’t necessarily make retirement less expensive but does allow the retirement portfolio to remain more liquid while securing a longevity insurance guarantee.

ANNUITY RISE RATE?
In the coming years, the real question is if, or how, longevity annuity rates will rise or not as the Federal Reserve raises interest rates. Although rate increases should boost payout rates, the major impact will be driven by rate changes at the long end of the yield curve and not necessarily by what the Fed does with short-term rates.

Any rate increase benefits must be weighed against the risk that continued medical advances improve life expectancy so much that longevity insurance rates must be decreased to account for longer life expectancies.

Nonetheless, the possibility remains that longevity annuity rates may eventually become competitive with or even dominate equities -- thanks to the boost of mortality credits -- in the same way that the longevity annuity can already dominate a purely fixed-income portfolio for generating retirement income. At a minimum, the longevity annuity is still the only solution that can take the risk of uncertain longevity and an unknown time horizon off the table altogether, so long as the longevity insurance companies themselves effectively manage the risk.

This story is part of a 30-day series on preparing for retirement. This story was originally published on Feb. 24.

Michael Kitces

Michael Kitces

Michael Kitces, a Financial Planning contributing writer, is a partner and director of wealth management for Pinnacle Advisory Group in Columbia, Md., co-founder of the XY Planning Network and publisher of the planning blog Nerd’s Eye View.