• Life insurance becomes more valuable if bad things happen.

• A life-time annuity becomes more valuable if good things happen.

As insurance products, life insurance and fixed annuities are sometimes explained as opposites of each other. A life insurance policy provides financial protection against one dying too soon, while an annuity, with its guarantee of lifetime payments, protects against one living too long.

Consumers can easily understand the rationale for life insurance. Life comes with no guarantees; accidents or other unforeseen events can end it abruptly. Life insurance is a prudent (and financially efficient) response to this risk, reducing the financial uncertainties that might result from an unexpected passing.

In contrast, financial commentators have long noted that consumers don’t appear to have a similar appreciation for annuities. In 1965, theoretical economist Menachem Yaari published a seminal research paper titled “Uncertain Lifetime, Life Insurance and the Theory of the Consumer.” Not a catchy title, but as one financial manager put it, “Today every graduate student in economics and insurance is forced to read this paper, for very good reason. To put it simply, he introduced and then legitimized life annuities to all economists.”

One of Yaari’s primary conclusions was that absent the desire to leave an inheritance, the most effective use of one’s accumulated savings was to purchase a lifetime annuity, i.e., a stream of payments guaranteed for as long as one lived. Yaari provided statistical evidence that lifetime annuities resulted in higher payments and lower risk, and subsequent studies have confirmed this finding.

Yet economists have also noted that relatively few consumers buy lifetime annuities. They even have a name for this behavior: “The Annuity Puzzle.” Why don’t more people make a rational economic decision to use their savings to purchase lifetime annuities?

The prevailing answer: People are not rational; they make stupid choices. But this simplistic perspective may overlook some very logical reasons for consumers not to annuitize their savings. Instead, they might be better served by buying life and disability insurance.

Researchers Felix Reiching and Kent Smithers are the authors of a working paper on why annuities may not always be the optimal choice for retirement. In an interview with AdvisorOne, Smithers articulated the main points of their study.

• Consumers have two great financial risks during their lifetime. While they are working, the big risk is they become disabled, and lose their ability to earn an income. When they retire, the big risk is they incur large medical expenses, particularly to pay for long-term care, and lose their savings.

• Both of these events are financial shocks that require a dramatic re-ordering of one’s financial life. But not only finances are affected. Each of these events—a disability or a long-term care situation—decreases life expectancy. And diminished life expectancies affect the current value of insurance assets.

Smithers presents the example of someone receiving a life-time annuity payment in retirement who incurs large expenses from a long-term care incident. On the secondary market, the annuitant could exchange his/her lifetime payments for a lump-sum (“It’s my money and I want it now.”) But because of the change in health status—one is likely to die sooner—the lump-sum value of the annuity will be diminished.

In the same circumstance, Smithers explains that a consumer receives a “negative annuity” from life insurance; while a lifetime annuity becomes more valuable the longer one lives, an existing life insurance policy becomes more valuable with decreased life expectancy. If one wanted to assign life insurance benefits in exchange for a lump-sum to meet long-term care expenses, the amount received would be higher because of diminished life expectancy.

This observation, that some insurance benefits become more valuable when life expectancy declines, is an interesting twist. In general, Smithers thinks consumers realize greater financial value when they obtain, at an early age, the types of insurance that increase in value, should either of two great financial shocks occur later in their lifetimes. His comment: “Most younger people should negatively annuitize, which they can do by buying a fair amount of life insurance.”

Conversely, because an incident of disability or long-term care has a negative impact on the present value of a lifetime annuity, Reiching and Smithers see their infrequent purchase as a rational decision by most consumers (although Summers also says older purchasers of life-time annuities “can get a very large return”).

If you understand this financial paradigm for insurance, a logical application is to secure life, disability, and long-term care insurance when you are young, healthy, and can be insured at the most favorable rates. This concept also implies that life insurance should be viewed as a long-term—if not lifetime—asset. If you encounter a financial shock because of a disability or long-term care, you want the negative annuity qualities of life insurance to absorb the blow.

Is your insurance program structured to deliver maximum value under all circumstances?

By Elozor Preil