Insurance against longevity
Longevity, is one of the imponderables to consider, when one reaches retirement. This question is how long will you live? Real problems arise when having contributed into superannuation and now a superannuation lump sum is available to you but, it has to last an indeterminate lifetime. One option available is to apply the lump sum to purchase a guaranteed life annuity.
A guaranteed life annuity pays out every year until, the annuitant specified under the contract, dies. A life annuity is therefore a compelling product as it “insures” you against longevity—living a long time, and thus risking running out of retirement income streams, while you are enjoying a long life. A guaranteed life annuity thus reduces the financial risk that comes with living into old age.
Risk of living too long
An annuitant living too long, beyond normal life expectancy, will accordingly gain from having taken out a life annuity. You will have protected yourself against the adverse financial consequences of longevity. Guaranteed life annuities are therefore very attractive to the healthy, as an income stream is guaranteed for the whole of one’s lifetime. Life expectancies for Australians are among the longest in the world and forecast to increase further but generally, people do not appreciate what their life expectancy is. This eliminates some of the financial implications of longevity, but the unhealthy could expect to lose out from buying a life annuity.
The result is that in entering into a life annuity contract there is a fear that the issuer of the annuity will fail, alternatively that the annuitant will die, very soon after taking the contract, the result being a windfall for the insurance company. In any event, the annuitant will lose the outstanding balance of one’s capital at death. Thus taking a life annuity is generally seen as a gamble.
Safety of annuities
However, issuers of annuities are life insurance companies, that are well regulated by the Australian and Prudential and Regulatory Authority, and are required to hold their assets in segregated funds. Furthermore, Life Insurance companies make adjustments to the contracted level of income through margins to run their operations, cover the risk associated with the assets backing the life annuities and to cater for an adverse selection against them were their life annuity products are taken by those who are more healthy than the general population.
Risk of dying young
An option available to purchasers to address the risks they perceive is to take joint and survivor guaranteed annuities. This annuity is issued with reference to the life of the annuitant and a dependant of the annuitant, usually the spouse. The annuity is guaranteed to be payable during the life of both the annuitant and continue for the lifetime of the joint annuitant.
Joint and survivor annuities may be structured to pay a constant amount throughout the lives of the two persons, or alternatively there may be a reduction in the annuity income level after the death of the first dying. This results in higher income levels to be paid initially.
Protecting capital in annuity
Although the focus of life annuities is to address longevity risk you may unnecessarily forfeit your capital if you die prematurely. To overcome the aversion to possibly losing capital, in the event of premature death, life annuity issuers have been offering a withdrawal guarantee for a substantial portion of the capital for and initial time of up to 15 years.
Does downside protection have its downside?