If you think saving for retirement is hard, wait until you start thinking about how to make the money last.
It's a challenge that policymakers are focusing on more intently, especially since features like automatic enrollment are encouraging people to save more.
Some 55 percent of workers in a 2014 survey by the Employee Benefit Research Institute were at least somewhat confident about having enough money for retirement, including 18 percent who were highly confident. That's an improvement from 2013, when just 13 percent were highly confident their nest egg was big enough. But many of those investors don't seem to have a handle on how much money they can and should draw down after they stop working.
"So much of the attention in 401(k) policy has been in getting people to save. Now some people have done that, and now the issue is well, what do they do with the money when they retire?" said Richard Johnson, a senior fellow and director of the program on retirement policy at the Urban Institute.
People seem to be either shortsighted or overcautious with their savings, Johnson added, but either way, they are not making optimal use of the money. "The traditional fear is that people will outlive their assets. But when we look at the data, the opposite is happening. People are so afraid they will run out of money that they don't spend down their 401(k) savings."
Enter longevity annuities. These annuities, a type of deferred income annuity, allow investors to pay an upfront premium in exchange for a stream of payments starting at a later date, like when they turn 85. The initial cost of these annuities is much lower than an annuity that starts paying, or annuitizing, right away, and they enable investors to make sure they have income in old age and to define how long their other savings have to last.
Longevity annuities have been around for a long time. Moshe Milevsky, an associate professor of finance at York University's Schulich School of Business, said that three centuries ago, governments in England and France were issuing this kind of contract to pay for government operations.
But in the past year, longevity annuities have gotten a boost from policymakers. Last July, the IRS completed rules that allow people to put the lesser of 25 percent of their IRA assets or $125,000 into a so-called qualified longevity annuity contract, or QLAC.
A QLAC starts paying out at a later date, like when the investor is 80 or 85, and investors do not have to factor in the assets in the QLAC when they calculate the minimum required distribution they have to take from their employer-sponsored retirement accounts. In effect, a longevity annuity that is structured to fit the QLAC rules can provide deferred income for later life, and reduce the amount retired investors have to take as annual taxable distributions from a 401(k) or similar account.
Then last October, the Treasury Department and the IRS approved guidance making it clear that employers can offer deferred-income annuities in target-date funds that are used as default investments in retirement plans they sponsor.
With assets in 401(k) plans at $4.5 trillion as of the third quarter of 2014, up from $1.7 trillion in 2000, the rule changes could lead to a sharp increase in the amount of money Americans set aside for very old age.
But are longevity annuities right for you? It depends.
With interest rates currently low, the payments from any annuity priced today are likely to be relatively modest, experts say. In addition, if interest rates rise, the price of a longevity annuity with payouts at today's levels will decline.
There is also the risk that inflation will erode the real value of the payments you receive. While inflation is low right now, there is no guarantee that it will remain that way until your longevity annuity starts to pay out.
In addition, because these contracts do not pay out for a number of years, there is a chance that you may die before the payments even begin, or the company issuing the annuity may go out of business.
There is another factor to consider as well: gender. Current rules state that QLACs, the longevity annuities that get the more favorable treatment in employer-sponsored retirement accounts, are priced as a unisex product. That means the payments from the contracts will be based on an expected life span that is longer than a typical man's and shorter than a woman's. As a result, each payment could be smaller than what a man could receive on another type of deferred income annuity, and larger than what a women might get. That rule makes a QLAC as currently designed a somewhat questionable proposition for men, but relatively attractive for women.
Women are "who it's ultimately going to be most important for," said Harold Evensky of Evensky & Katz Wealth Management. Between their longer life expectancies and typically smaller savings, "they are the ones most likely to need to get as much as possible from what little is available."
Investors can reduce or eliminate many of these drawbacks by paying for added features. For example, investors can add a provision that payments are to increase by a fixed amount to offset the toll inflation may take, or a money-back guarantee to protect heirs against the chance that an annuity holder dies before payments start.
But features like these will cut into the size of the payments investors can expect. And insurance companies are not required to reveal the direct cost of these add–ons, according to Joseph Montminy of the LIMRA Secure Retirement Institute. Instead, they simply disclose the new size of the periodic payout.
"They don't say 'it costs $10 for every $1,000 you put in," Montminy said. "The expenses are baked in."
That means investors have to be vigilant when they shop around for longevity annuities. "Make sure you are comparing apples to apples, the exact same kind of payout," Montminy warned.
Milevsky suggested using what he called "damaged money" to buy a longevity annuity and offset some of the risks. For example, if you take money out of bonds to buy the product and interest rates rise, the prices on annuities will fall—but you will have saved yourself from losses on your bonds.
In any case, he said, "this isn't an investment—it's a hedge against longevity risk," the risk that you will outlive your financial assets.
With very few QLACs yet created, the market for these longevity annuity contracts is just beginning to develop. But experts think the growth in the market could be significant if a number of big players develop products. For one thing, the market for deferred-income annuities in general has been expanding rapidly for several years as investors search for income protection in old age. Sales in 2011 were around $200 million, Montminy said, and for 2014 they are on track to reach $2.7 billion to $2.8 billion.
As a result, even with the risks and drawbacks in QLACs and other longevity annuities, Montminy and others are watching closely.
Evensky, for one, is not recommending these annuities for clients now because of the low interest rate environment. But eventually, he expects longevity annuities to be "an extraordinarily important vehicle."
You may have only a 20 percent chance that you will live to 95, Evensky added. But if you do, and you have only planned financially to reach 85, "you will be eating cat food for a decade."