Monday, September 15, 2008

Life Annuities and Longevity Risk

Unlike most investing products, life annuities actually solve a problem that do-it-yourself investors have difficulty handling on their own: longevity risk. By controlling my own investments with low-cost index ETFs, I can beat most professionally-managed mutual funds. However, when it comes to my retirement years, it will be hard to decide how much money it’s safe to spend because I don’t know how long I’ll live.

If you control your own investments, the only practical approach in your retirement years is to spend little enough that your money will last to the end of a very long life. Just because the odds are only, say, 50% that you’ll make it to age 80, that doesn’t mean that you can get away with saving only half a year’s worth of spending money for your eighty-first year. If you make it to age 80, you’ll need a whole year’s worth of money.

Life annuities are an insurance product designed to solve this problem. The insurance company takes a lump sum of money from you and pays you a monthly amount for the rest of your life, no matter how short or long your life turns out to be. This transfers the longevity risk from you to the insurance company. It also eliminates any inheritance.

The insurance company reduces risk by selling many life annuities. They can predict with reasonable certainty how many people will live to each age. So, if only half the people will make it to age 80, the insurance company will only have to pay half as much by then. The savings the insurance company expects over time allows them to increase the monthly payments everyone gets right from the first month.

So, with the longevity risk significantly reduced and with everything else being equal, a life annuity allows you to spend more each month than if you handled your own investments. Unfortunately, everything else isn’t equal. Insurance companies have to pay executive salaries and salespeople’s commissions somehow. These costs come out of the lump sum you hand over to the insurance company when you buy the life annuity.

Another factor is that the insurance company might not invest the money the same way that you would. If they are conservative and use mostly fixed-income investments, then you’re very likely to get less than if the money were invested in stocks.

Overall, I don’t have an answer to the question of whether a life annuity is better than investing on your own throughout retirement. But, I tried to come up with a way to have your cake and eat it too. By this I mean can we reduce longevity risk and cut out all the hefty fees and commissions?

One possibility is to pool retirement funds with other individuals to spread out longevity risk. Suppose that 20 people pool their money. At first withdrawals are split 20 ways, but as the participants die off, the withdrawals get split 19 ways, then 18 ways, and so on. The idea is that after you die, your share goes to the survivors.

It’s all a bit morbid, but it could work out well if there aren’t any serious conflicts. Draining the money to pay lawyers over a squabble would be a problem. Another problem that might make an interesting movie is that each person would have a financial incentive to bump off the others.

Despite what many people seem to believe, individual investors with a little knowledge can usually get better returns than the professionals. Reducing longevity risk is one of the few significant ways that professionals handling big piles of money have an edge over the little guy.


  1. Your idea of the pooled investment was actually not unusual many (many) years ago - called a tontine structure. It was indeed the fodder for many murder mystery stories since it does create an incentive to do away with the other investors. I think a Hitchcock movie or some other famous movie is based on this.

    Most countries have deemed them to be illegal now.

    The annuities do have options to allow for inheritances, or continued benefits to a spouse/partner - but every bell and whistle added to a plain straight life annuity decreases the monthly payment amount.

    Many people will get an annuity with a COLA rider (cost of living adjustment to increase the payout by inflation or a set percentage each year) to cover the bare necessity living expenses and then invest the rest themselves. Practically, I've found this to be a good middle ground.

  2. Very clever. Actually, there was a variant of this in the Simpsons episode: "Raging Abe Simpson and His Grumbling Grandson in 'The Curse of the Flying Hellfish'".

    Grandpa Simpson and his army unit made a pact, such that the last living member got the paintings they pilfered from Germany. Such an agreement is called a "tontine", apparently:

  3. Gene: Maybe a theme for some blog posts could be "investing ideas from the Simpsons." The difference between my proposal and a tontine of the Simpsons' type is that the survivors are draining the pot of money constantly so that the last survivor should end up with just a small slice of the original.

  4. Preet: Some sort of glitch caused your comment to be lost for a while. Your middle ground idea seems good to me -- use a small annuity with COLA as protection from cat food and go for the good life by investing the rest on your own.

  5. Michael
    I agree life annuities should be considered by many do-it-yourself investors.
    I have recently published the first in a series of commentaries on longevity risk. You can find it at
    Marc Ryan

  6. A longevity annuity can be used to augment retirement income. You can invest a small portion of your savings and the annuity payments begins at a future date during your retirement. The income can help to make up for inflation or investment loses.
    There is a website that explains how longevity annuities work What do you think?

  7. Michael James,

    The question is in retirement, can one get 6% or 8% and still pay little taxes vs. stocks or ETF's and is guaranteed?

    Markets go up up and down and you don't want to put all your money in annuities. But if you want to enjoy life rather than follow the markets ups and downs and pay less taxes then annuities is something to consider. The problem is this is the end game without life insurance (which is risk management) most people will not pick up on as a back-up plan.