Are Longevity Insurance Policies a Smart Buy? Maybe Someday, But Not Now
It used to be that our grandparents worried about what would happen to their kids if they died too soon. Nowadays, our kids worry about what will happen to them, if we live too long.
Extended longevity is both a blessing and a curse. The blessings are well known and innumerable. But we are also cursed with extra time to fear death and more time to worry about our added longevity stripping us of the cash required to comfortably support those “bonus” years. In short, most folks are now more concerned about the cost of living too long, than they are about the cost of dying too soon.
A New Opportunity is Waiting
The life insurance industry achieved exceptional success and became comfortable offering products that protected against the cost of dying too soon. But it has taken the industry several decades and a number of fits and failures to (grudgingly) recognize and accept this fundamental change in consumer needs.
Despite the admonitions of some within the industry, the idea of accepting – even acknowledging – change has not been easy for the life insurance industry. Historically accustomed as it was to selling the products it wanted to sell versus products the consumer sought to buy, the life insurance industry’s initial response to the threats posed by this change was a call to “get back to the basics.” The problem for the life insurance industry was that the basics had changed and clinging to the past simply exacerbated the problems.
The Writing on the Wall was not in Invisible Ink
It’s not like the life insurance industry was not warned. As long as three decades ago, the signs of change – for those who were open to seeing them – were clearly evident. Life expectancy at the start of the 20th century was a mere 42 years; by the end of the century it had dramatically increased to age 74; with predictions that it would soon extend well into the 80s.
These remarkable statistics and a number of other factors signaled the need for change, but it was this extension of longevity that led the consumer to conclude that the fundamental products offered by the life insurance industry had become outmoded.
The life insurance industry has finally been dragged kicking and screaming into the future, but because of its intransigent allegiance to the past, it may be too late to recover what it has lost. Now that the life insurance industry has accepted the premise that it must change – if it is to survive – and offer products that protect against the cost of longevity, it is struggling with just how to do so.
Many believe that the business of insurance companies is to take risks, but that is not the case. (At least that’s not the approach for those companies that survive.) The path to success in the insurance industry is not to assume the risk of loss, but to manage the risk of loss faced by others. In order to do this, the insurance company must fully understand all aspects of the risk, so it can be managed.
The life insurance industry has more than 150 years of experience designing products that cover the costs of dying. This experience enables the industry to comfortably manage the risk of dying, without assuming much risk. Given any group of insureds, the life insurance industry can forecast – with virtual prescient certainty – when and how many in that group will die during any given period of time.
On the other hand, the life insurance industry has only a smidgeon of experience understanding the risks inherent in what could be called the “longevity market”: offering income products that meet the costs of living. An insurance company can use life expectancy tables to determine when people will die, but it has no experience projecting how many individuals in a group will live beyond – and for how long – the moving target of life expectancy.
This means the insurance company is, in effect, making a guess (taking a risk) as to how many insureds will live longer than expected and what the duration of those claims – life income – will be. In addition, interest rates have a dramatic effect on the amount and cost of income benefits. And since interest rates, another moving target, cannot be predicted for even the next year, it is a significant risk for insurance companies to try to project interest rates over decades.
The Unwelcome Upshot of All This
Faced with this dual conundrum, the prudent insurance company will tend to develop products for the “longevity market” that are loaded with hedges, protections and benefits for the company, but not so many for the consumer. This is to be expected, because insurance companies do not (and should not) assume risks they don’t understand or can’t manage. As a result, the tactic taken by insurance companies in the design of these first-generation longevity products is to transfer as much risk as possible to the insured. And this will continue to be the approach until the industry gains experience and confidence in the management of those risks. In the meantime, it’s buyer beware.
The concept and objective of these longevity policies is fine, but they are so loaded with protections for the insurance company, they don’t yet offer good value for the consumer and should be avoided. It’s not that these products are bad, it’s that they are not as good as they could or will be and the cost benefit for the consumer is not well balanced.
These products are the insurance industry’s first response to meet the concerns an individual may have that they will “outlive” their assets and income. They may have enough money to get to age 75, but what if they live to 95? The basic structure of “longevity insurance” is for the purchaser to deposit a lump-sum amount with the insurance company, with the understanding that no benefits will be paid unless and until a person lives to a predetermined age. For example, a 55-year-old deposits $50,000 with the insurance company to buy a longevity policy. The policy would pay no benefits whatsoever until age 85. At that time, the company would begin to pay about $50,000 a year, for as long as the insured lived.
This type of policy certainly solves the “longevity problem,” but it comes at a very high price with few options for the insured. For one thing, once the deposit is paid to the insurance company, it belongs to the insurance company and may never be returned. The insured gives up all control and access to the money and if they change their mind or have an emergency need for cash, they are out of luck.
That means an individual age 55 could deposit $50,000 or more with an insurance company and if they don’t live to age 85, they lose all the money deposited. The only chance they have to get their money back is to live. Even then, if the insured does live to 85, and dies a year or two later, the funds are lost. In fact, insurance companies anticipate that so many of those who buy the policy will not live to collect any benefits they count on using these forfeited funds to pay those who do live. (In fairness, some companies do offer the insured options that would, under certain circumstances, allow for a return of this premium, but the costs are so prohibitive they virtually eliminate the basic value of these policies.)
There are other problems with the policy as well. For one thing, benefits are set and guaranteed at the time the policy is purchased. With current interest rates at such low levels, this may be the worst time to buy a policy that locks in current rates for, what could be, 30 years or more. Any increase in investment rates between now and when benefit payments commence (if they ever do) would benefit the company, not the policyholder. Another concern for the policyholder could be inflation. A guarantee of $50,000 a year income may seem good today, but what will its value in purchasing power be in 30 years?
There is another issue a potential purchaser of these longevity policies should consider. It is what investors call the “credit risk.” When buyers deposit their funds with the insurance company, they are taking the credit risk that the company will be around in 30 years and will be able to meet its obligations. This is a relatively low risk decision, but if the insurance company mismanages the investments backing these policies, if more people live than anticipated live to receive benefits and those receiving income live longer than planned, the insurance company could be squeezed to meet its promises.
So what is someone who is concerned about the economic costs of living too long to do?
Well truth be told, these “longevity insurance” policies are not all that revolutionary and are not worth the cost or the risk the insured must assume in order to receive benefits. In effect, the core of these policies is a single premium deferred annuity. In a single premium deferred annuity the insured makes a single deposit of funds, allows those funds to accumulate over time and then, at a later date, can elect to receive an income for as long as they live. The risk the insured is taking by purchasing this type of policy is that it is impossible to know exactly what the income will be when they elect to receive it.
What makes the longevity policy unique is that the insurance company will guarantee what that income will be. That’s great. But the costs applied by the insurance company to receive this benefit are just not worth it. The insured must give up the right to get their funds refunded if their needs change. If they need cash for unexpected purchases or emergencies, they must find it elsewhere. If they die before receiving any benefits, their family receives nothing. They have only one chance to receive income and that is they must hang on until they reach 85 and if they die a month before or a month after income starts, that’s the end of the income stream. All these costs and limitations outweigh the value of the insurance company’s guarantee as to what the income will be at age 85.
In the Meantime, Here’s the Smart Choice
Until the insurance companies gain the experience and desire to develop improved iterations of longevity insurance, the consumer is better served by purchasing a traditional single premium deferred annuity. This keeps all the options on the side of the consumer, while still offering a guaranteed income to cover the cost of longevity. The only risk for the consumer has is not knowing exactly what that income will be when they elect it, but that risk is slight and is a fair exchange for the high costs of current longevity insurance policies. This is the best way, at least for now, to enjoy your longevity, for as long as it lasts.