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Ways to manage longevity risk

The acid test of a retirement plan is a long life. Expenses grow faster than incomes and by late retirement many people have almost exhausted their savings. That occurs frequently enough that there are now financial planning courses devoted to longevity risk and the ways to manage it.

One problem is that people often underestimate by several years how long they will live. Some 40% of retirees and pre-retirees will outlive by five or more years the average remaining life expectancy for people their age, according to a 2011 survey by the Society of Actuaries. Most of those surveyed said they would be willing to spend less in early retirement if they knew they were going to live five years longer than they thought.

A second problem is that people don’t understand the extent to which health care costs will take ever-larger chunks of their incomes as they age. Last year Fidelity Investments estimated than a 65-year-old couple without employer coverage will spend $220,000 for health care during their retirement, not including any long-term care costs. Fidelity assumed the husband will live to age 82 and the wife to age 85. But this estimate balloons to $355,000 if the husband lives to age 92 and the wife to age 94, according to a Fidelity executive quoted in a New York Times article.

To get an idea of the impact that late-life health care spending can have on your finances, consider the projections in the Medicare trustees 2013 report. The trustees estimate that out-of-pocket health care spending will grow at an average annual rate of 3.8% for the foreseeable future. That is 1% more each year than the trustees’ projected growth in GDP. If the estimates are accurate, today’s 65-year-old woman who lives another 30 years will pay one-fourth of her retirement health care costs after her 90th birthday. And her health care expenses will have increased by one-third again as much as other costs.

Unless you’re wealthy or have a solid defined-benefit pension plan to supplement your Social Security check, you may at some point need to convert one or more of your assets into a steady income stream. Homes and cash-value life insurance policies are frequently converted and can be especially valuable if they were purchased years ago (last month’s blog dealt with ways to use reverse mortgages to tap home equity). Other choices are immediate and deferred annuities, and in a few cases long-term care insurance. Here’s a rundown of the pros and cons of these commonly used options:

An immediate annuity is a way to buy your own pension. In return for a one-time premium, the insurance company will send you a monthly check for the rest of your life. With a joint annuity, the monthly check will continue as long as either you or your spouse is living. That stable income allows you to put some of your remaining savings in slightly riskier investments that offer higher long-term returns, e.g., stocks.

The size of the monthly payments you receive will depend not just on the premium you pay, but on your age, gender, and current interest rates. Because interest rates are near historic lows, now is not a good time to invest in an immediate annuity. Some financial advisors recommend that you buy immediate annuities in increments to spread interest rate risk. Instead of buying one annuity for $100,000, you might buy four $25,000 annuities over a period of several years.

If you want to add guarantees to your annuity, they will reduce the monthly payment amount. As an example, if you want to keep payments coming not just for as long as you live, but for as long as either you or your spouse is alive, that extra guarantee means you’ll get a smaller check each month. And if you want to make sure that your payments continue for a specified number of years should you die soon after purchase, you can add a “period-certain” guarantee for 5, 10, or 15 years, with payments after your death going to your heirs.

When you invest in annuity, you do so through a licensed insurance agent. But it’s also best if you get independent advice before buying, since the licensed agent can only direct you to specific products. If possible, use after-tax dollars for your premium — not money from a tax-deferred IRA or 401k. Then you will be taxed only on the gain, which is calculated over your remaining life expectancy. Finally, it’s safer buy an immediate fixed annuity, not a variable one.

The web site immediateannuities.com will give you an idea of your monthly payment amounts with various guarantees. Also, it’s wise to get quotes from salaried agents who are not paid on commission. Fidelity, T. Rowe Price, and Vanguard’s annuity agents, for example, do not receive commissions. Likewise you can get an inflation-adjusted annuity through Vanguard, with lower initial payments that will increase as you age.

Deferred annuities can be good investments since you won’t owe taxes until you take money out. The simplest form of longevity insurance is a deferred annuity which will pay off only if you live to a certain age (age 85 is commonly used). In this pure form of insurance, you won’t get any money back unless you reach the specified age. Therefore you plunk down $50,000 at age 60 with the promise that beginning on your 85th birthday, you’ll receive $50,000 a year for the rest of your life. But if you die at age 84, you receive nothing.

Deferred annuities are ten times more complex than immediate annuities. Most contracts are burdened with fine print about surrender provisions, penalties for early withdrawals, and minimum fixed-interest periods. And no two of these investments are exactly alike.

If you invest in a deferred annuity when you are younger, by the time you are in your 80s your money has had time to grow tax-deferred. Along the way, you can annuitize all or a portion of your investments as you wish. Gains on your original investments are subject to ordinary income tax rates that you or your heirs will pay.

Many deferred annuities have fees in excess of 2% a year. When shopping, seek help from a fee-only financial planner who won’t steer you to a particular product on which he or she receives a commission. As with immediate annuities, compare products from Fidelity, T. Rowe Price, and Vanguard, all of which sell deferred annuities that have low fees. As a general rule, fixed annuities are better if you think you may need the money within a few years, and variable annuities will outperform over long periods. A good balance is to have some portion in fixed assets and the remainder in stocks.

Cash value life insurance should be purchased only if you are still working. Once you’re retired there’s less need for life insurance. But if you own a cash value policy at retirement, it is a versatile tool that you can use in several ways. You can withdraw funds from the cash value, borrow against the cash value, or exchange the policy for an annuity, either immediate or deferred. In most cases you can do any of these without owing taxes.

Or you can keep the policy current, retaining your flexibility to draw cash from it later when you want to remodel your den. If you bought the policy when you were still working, your premiums should be reasonable. As with other kinds of longevity protection, unless you’re an insurance expert you shouldn’t choose your strategy without help from someone who is knowledgeable and does not have a vested interests in your decision.

Long-term care insurance helps to insulate you from the potentially enormous cost of custodial care. The most recent Metlife survey found that the cost of a nursing home stay in a semi-private room averaged more than $81,000 a year in 2012, with a private room costing $90,500 a year. To pay for these rising costs, LCTI premiums continue to soar. In California last month, John Hancock Life and Health Insurance announced that its premiums on existing policies will rise by as much as 90%. That’s why some pundits say the only people who can afford LTCI policies are the ones who don’t need them.

LTCI policies have always been products for a niche market, but increasingly it’s a tiny and shrinking niche. Of the 14 companies that sold LTCI policies a few years ago, only six are currently writing new coverage. Making it worse, the two essential features of a good LTCI policy are the return-of-premium provision and inflation protection, but adding those two protections will often hike premiums by an extra 50%.

The feature that people most dislike about LTCI policies is their use-it-or-lose character, which the return-of-premium only partly addresses. Hybrid policies combining LTCI with either a life insurance policy or an annuity have grown in popularity because of the assurance that the money will not be lost. And money used for eligible long-term care expenses is generally not taxed when it comes from a long-term care rider in a life insurance policy or an annuity. ◊◊


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