Yogi Berra once suggested, "The future ain't what it used to be." Advisors should pay heed to Mr. Berra's observation and be aware that America's changing demographics will likely impact their clients. Advisors should also be weary of those who estimate their ability to receive future income based on mathematical extrapolations calculated from ‘average' historical returns in investments that are subject to market fluctuation. Failure to proactively address longevity and market risk can jeopardize the lifetime success of a financial plan.
A key statistic potential retirees should understand is that longevity appears to be on the rise. A February 1996 The US Census Bureau's Current Population Reports estimated that by 2050 men's average life expectancy would increase from 72.5 to 79.7 years while women's average life expectancy would increase from 79.3 to 84.3 years. However a more recent report issued by the Society of Actuaries in 2005 titled Analysis of Trends in the Age-Specific Shape of Mortality Curves for Populations in the United States and Japan estimates current average life expectancy at about 80.9 years for men and 86.6 years for women projected to grow to 84.6 years for men and 89.6 years for woman by 2030.
In an attempt to overcome the planning difficulties presented by long life, some financial pundits advocate that consumers simply assume more risk in their investment portfolios to seek higher returns. Considering the volatility experienced by many over the last decade it's baffling that people are still willing to openly embrace such strategy.
Ironically, potential retirees embrace the concept of risk transfer throughout their working lives but largely exclude it in retirement. They use life insurance to transfer mortality risk, auto & home owners insurance to transfer liability risk, and health & disability insurance to transfer morbidity risk. Potential retirees should also be using immediate annuities to transfer longevity and investment market risk.
When an immediate annuity is purchased, the consumer (or annuitant) is transferring longevity and market risks to an insurance company that is more efficiently equipped to manage the risks. Insurance companies have the ability to pool longevity and market risks over a large statistical sample of annuitants, insurance companies can also match the duration of their investment portfolios to coincide with the maturity of their obligations. Individual investors don't have this luxury.
In transferring longevity and market risks a retiree is protected from the financial damage that occurs when a person has consumed all of their assets. They also gain and peace of mind that is lost when attempting to assume all of the risks associated with managing an investment portfolio to meet a longevity target that is difficult to estimate, in an investment market that is influenced by factors outside of an individual's control. Financial advisors and retirees at times delude themselves that they can ‘self insure' against longevity and market risks purely through asset allocation and portfolio rebalancing strategies. Simply put, ‘self insurance' means no insurance; when a retiree runs out of money at an advanced age with no way to produce income the consequences are staggering.
Given that immediate annuities can be designed to include cash refund features, period certain payments, inflation adjusted payments, and joint life income streams it is possible to use one or more immediate annuities to design a plan of guaranteed income that meets many retiree's desires. As the American population continues to age retirees may be less able to rely on government or corporate guarantees for income during retirement. Financial advisors and financial consumers should evaluate the use of immediate annuities to relieve the stress that longevity and market risks place on the long term success of an investment portfolio.