Earlier this week, we looked at the importance of incorporating different types of risk—specifically, human capital risk—into an overall financial plan. Today I will focus on mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.
For those families whose human capital makes up a substantial portion of their total assets, protecting that capital via the purchase of life insurance should be part of the overall financial plan. Life insurance is the perfect hedge for mortality risk because its return is 100% negatively correlated with the human capital asset.
The younger the investor (the higher the human capital), the greater the need for life insurance. The amount of insurance required can be determined through what’s called a “needs analysis.” It can also be related to bequeathal motivations.
It’s important to note that life insurance can be used for purposes other than to hedge mortality risk. For example, it may be the most effective way to pay estate taxes. It can also be useful in terms of business continuity risks. Thus, while the individual’s need for insurance to hedge the risks of human capital falls as he or she ages, the need for life insurance might actually increase.
Longevity risk is the risk that you will outlive the ability of your portfolio to support your desired lifestyle. This risk has increased for much of the population with the decline of defined benefit plans (which, like social security, pay out for a lifetime) in favor of defined contribution plans. Also, advances in medical science continue to expand life expectancy. Longevity risk can be addressed by the purchase of lifetime payout annuities.
While the academic literature demonstrates that many investors would benefit greatly from the purchase of immediate annuities or deferred income annuities (because of “mortality credits” built into the product—in effect, people who die earlier than expected subsidize those who live longer than expected), very few are purchased.
The main reason seems to be that people are risk averse, in the sense that they don’t want to risk giving up their assets and then dying soon. The fear is that the assets would no longer be available for their heirs. But this is only true if they live a shorter-than-average life span. By definition, half will live longer. And for them, buying a payout annuity preserves any remaining assets for the estate.