Most people are pretty familiar with the basic idea behind life insurance. Essentially, in the unfortunate event of your untimely death, the policy pays out a death benefit to your named beneficiary or estate—replacing income and providing guaranteed liquidity for your estate.
But what about the opposite risk?
What if, instead of getting insurance that pays out to your beneficiaries in the event you die too soon, what if you want insurance that pays out as long as you live?
All things considered; a long, healthy life is a good thing. But, for retirees on a budget, it can raise the specter of outliving your retirement savings—a situation financial planners call “longevity risk.”
Now, as it turns out, insurance companies are well-aware of the twin risks of dying earlier or later than anticipated. And they offer complementary financial products designed as a hedge against either (or both): life insurance and annuities.
Annuities are sometimes described as “reverse life insurance” because—at least on the surface—they are designed to protect against the opposite risk. Interestingly, though, the two products also have many similarities and can be used symbiotically as part of an estate or retirement plan.
n annuity is a contract with an insurance company in which, in exchange for one or more premium payments, the insurer guarantees it will make regular annuity payments in the future.
Annuities can be fixed annuities and variable annuities. As the name implies, a fixed annuity has a fixed return set by the insurer. A variable annuity has a variable return determined by the return of the fund the annuity is invested in.
Annuities can vary tremendously depending on
By way of example, a popular choice for recent retirees is what is known as a single-premium income annuity (“SPIA”). The annuity contract is purchased with one large, lump sum payment (often from retirement savings) and then pays out on a predefined schedule for the rest of the annuitant’s life. With guaranteed payments for life, SPIAs act as a hedge against the risk of living beyond life expectancy and exhausting retirement savings.
Commonalities Between Life Insurance and Annuities
Though life insurance and annuities are essentially insurance against opposing risks, the two products actually have quite a lot in common.
Both are purchased from life insurance companies, and both involve a trade-off of one or more premiums upfront in return for future financial benefits from the insurance company.
The premiums required for either product usually depend on your age, life expectancy, and health status. Typically, older applicants will pay higher premiums for life insurance but lower premiums for a life income annuity (everything else being equal).
Both products also have a cash value that grows and can be used as a means of support in retirement.
And, in either case, the growth is “tax deferred,” which means that the interest or other earnings do not result in any current tax liability until the money is actually received from the insurance company. This might sound like a trivial question of tax policy, but, in practice, deferred growth results in very real economic benefits.
Real economic benefits, such as…
Rather than losing some value to yearly income tax, all growth earned by an annuity or life insurance policy can remain in place, compounding and earning even more growth.
Over time, the total cash value is significantly increased as a result. And, by the time the earnings are actually received, there’s a good chance you’ll be retired and paying income taxes at a considerably lower rate.
Deferred annuities are a particularly good way to limit your overall tax liability. If you purchase a deferred annuity during your prime working years, you won’t owe any taxes on the growth until the annuity starts paying out.
So, if annuitization doesn’t start until after retirement, you can often take advantage of a much lower rate. If the deferred annuity is “tax qualified,” the savings are even greater because you won’t owe taxes on the money used to fund the premium until after you retire.
Despite the similarities, life insurance and annuities have important differences as well. As mentioned above, the ultimate purpose of each product is different: an annuity pays you for getting old, while a life insurance policy pays your loved ones if you don’t.
Both products can help fund retirement, but annuities are more specifically geared toward that purpose. With life insurance, some of the premium is devoted toward underwriting the death benefit.
For the most part, life insurance policies require regular premiums over an extended period, and, when the policy matures, the beneficiary or policyholder gets a lump-sum back from the insurer.
Annuities, though, more commonly involve a lump sum payment, followed by payments from the insurer over time.
With that said, there are some life insurance policies that call for a single premium life insurance payment up front and annuities that allow for flexible premiums over time.
And, there are deferred annuities that pay out in a lump sum, and life insurance policies that allow for annuitization of the death benefit (or cash value) over time.
Both life insurance and annuities are flexible products, but the flexibility generally occurs at different times.
You see, once a policy is in place, life insurance offers numerous options for capitalizing on the policy’s value.
And with any given policy, you can choose to keep the policy in place or even overpay premiums to maximize the death benefit.
Or you can surrender the policy for cash or roll-over the value into an annuity.
And you might make a partial withdrawal of cash value or take out a loan against the policy.
Or you can exercise a “reduced paid-up nonforfeiture option,” under which the policy’s death benefit decreases but the need for future premiums is completely eliminated.
All of these options are available with most policies, and optional riders can allow for even more choices.