Worthwhile to Create Your Own Pension?Submitted by Grunden Financial Advisory, Inc on April 27th, 2012
A client of ours came across a story by the Wall Street Journal on how to create your own pension and asked for our comments. Knowing we have more than a few Wall Street Journal readers as clients, we would like to publish our reply on the subject, longevity insurance, for all to read.
To read the WSJ article in its entirety, please click here.
by Dave Ragan
Traditional defined benefit pensions are fading off into the distance. It is becoming increasingly rarer and rarer to see corporations offer to pay a certain percentage of a long-time employee’s salary through their retirement. These types of plans are usually to the advantage of the employees but are proving expensive to maintain for a variety of reasons. As a result, many companies are now only offering 401(K) plans which don’t have a promise of the company to pay a certain amount each month for retirement and can lead to uncertainty in retirement planning.
Pensions historically make up about a quarter of retiree income and Social Security makes up about 50% of the average retiree’s income. Combined, pensions and Social Security provide 75% of the income needed in retirement . If pensions are becoming a thing of the past and if Social Security has funding issues, more and more Americans are asking, “What if I outlive my retirement savings?”.
Enter: longevity insurance. Longevity insurance is basically a deferred annuity (which has been around a while) with a slightly new marketing twist. The premise is to purchase a single premium deferred annuity, let it grow, then annuitize it at a later date…the later date meaning when you think you might run out of money. Not taking payments immediately allows the future annuity payments to grow AND provides owners of this product some peace of mind knowing a “pension” will be there later in life no matter what. The longer the deferral, the larger the payments become. The annuitant (owner of the policy) benefits from the income when it begins and does provide some economic floor knowing some form of income is going to be there if retirement savings are depleted down the road.
These products can be a great solution for a targeted audience (like individuals who don’t want the stock market ups & downs), but certainly not for everyone because of the drawbacks (insurer’s solvency, fees, commissions, liquidity issues, inflation risk, and the insurer keeping your lump sum premium payment).
Another drawback, as mentioned in the article, is that annuity holders may end up sacrificing higher returns that might be available from the stock market. A perfect example of this is illustrated in the article when comparing how much income a $100,000 immediate annuity generates for a 65 year old male ($6,950/year) as opposed to waiting until age 85 for payments to begin ($63,990/annually)…quite a big difference. When one cannot handle any stock market volatility, the longevity insurance concept may be exact solution.
On the other hand, if one is willing to accept some investment risk in a hypothetical portfolio averaging 7.50% (returns not guaranteed), that same $100,000 investment would have grown to $446,082 over the course of 20 years (the same length of time used to grow the annuity payments). The average life expectancy of an 85 year old male is five years and he has a 50% chance at living this long. If this individual falls in the “average life expectancy category”, he’ll only be able to realize 5 payments of $63,990 ($319,950 in total). The real advantage is if he lives beyond age 95, then the annuity would be in his favor. Based on actuary tables, however, this individual only has a 14% chance at living to age 95 (the breakeven age).
It comes back around to one’s personal risk tolerance as it relates to achieving their financial goals. Products are out there which will insure against that “14% chance of living beyond the breakeven age”, but they do come with a cost….not just the cost of the product but the lost investment opportunity cost as well.