I recently wrote that people who buy life insurance are essentially lending money to insurance companies at an interest rate of about 2.5%, which is a good deal for the companies and a lousy investment for the policyholders.
Here’s something that’s even worse: qualified lifetime annuity contracts (QLACs), which are sold by insurance companies and other financial services companies.
QLACs are annuity contracts that pay a guaranteed monthly income for as long as a person lives. What sets QLACs apart from standard annuities is: (1) the annuity payments are deferred because they do not begin until several years after the contract is purchased; and (2) they can be purchased with tax-free withdrawals from retirement accounts (the annuity payments are taxable income).
A recent article in the Wall Street Journal noted that QLACs are typically purchased by people nearing retirement who are concerned about outliving their retirement savings. An example is a 65-year-old (let’s call him Bob) who purchases a $200,000 QLAC at age 65 and begins receiving monthly payments of $11,175 at age 85. That’s $134,100 per year, which sounds like a great return on a $200,000 investment.
However, this conclusion ignores two realities. The first is the miracle of compound interest. If Bob instead invests the $200,000 in stocks and earns an average annual return of 10% (about the historical average return on U.S. stocks), he will have over $1.3 million at age 85. Second, 54% of all 65-year-old American men do not live past the age of 85. If Bob dies before age 85, that’s $200,000 down the drain.
Bob can purchase a QLAC with a death benefit that returns the $200,000 to his heirs, minus any annuity payments made, but in that case his monthly annuity payments will be reduced from $11,175 to $7,000. It’s tempting to think that a QLAC with death benefits is an attractive option because heirs get back the initial costs. But that short-sighted thinking once again ignores the power of compound interest. There is an expensive opportunity cost to giving $200,000 to an insurance company and getting it back 10, 15, or 20 years later without interest.
What is the implied return on a QLAC? It’s complicated, but an enduring rule to remember is this: “If someone pretty smart offers to sell you an investment and it’s very difficult to figure out the return, chances are the return is pretty bad. ”
That is certainly the case here. To calculate the average rate of return for a QLAC, taking into account all possible ages at death, we need life tables showing the mortality probabilities per year for men and women of different ages, and a computer algorithm for calculating the implied death rates. returns with different levels of monthly income over an uncertain horizon.
When these factors are taken into account, the implied average return on QLACs is actually worse than the 2.5% average return on life insurance policies. For the examples given in the Journal article, the implied average annual return for individuals or couples of different ages ranges from 1.1% to 1.3%.
The only way QLACs can ever be financially attractive is if you live many, many years beyond your life expectancy. For example, if Bob buys a QLAC with a death benefit and lives to be 100, his implied annual return is 7.7%, which is closer, but still not as good as stocks.
Of course, there is no guarantee that even the healthiest 65-year-old will live to be a hundred years old. Accidents and unexpected illnesses occur. Only 0.7% of all 65-year-old men live to be 100 years old. QLACs are certainly more attractive to people who expect to live a long time, but to someone who at age 65 assumes he or she will live to be 100 or older. beyond that is delusional.
More realistically, suppose Bob is so healthy that he has the annual mortality rate of someone five years younger. So at 65 he is as healthy as a 60 year old; if he is 66, he has the chance of death of someone who is 61, and so on. The implied average returns in that scenario are increased slightly – to 2.3% with a death benefit and 2.7% without a death benefit, but QLACs are still a lot more financially attractive to companies that sell them.
Many investment strategies are based on the assumption that people are risk averse, but QLACs go beyond risk aversion and lead to risk phobia. Buyers sacrifice a lot to get very little. A more likely explanation for the appeal of QLACs is that buyers have no idea how bad the implied returns are.
Maybe QLACs are just an expensive way to protect people from making other bad decisions, like investing too cautiously (burying cash in the backyard?) or too impetuous (bitcoin anyone?), or living way beyond their means. For most people—who have other assets, Social Security income, and children to help when needed—lending money to an insurance company at 1 to 2 percent interest is a worthless investment.
Gary Smith, Fletcher Jones Professor of Economics at Pomona College, is the author of dozens of research articles and 16 books, most recently: “Distrust: Big Data, Data-Torturing, and the Assault on Science” (Oxford University Press, 2023) .