Retirement Planning: Longevity Risk

Key Insights

• Running out of money during your lifetime – longevity risk – is one of the biggest fears people have in retirement

• Unknown and lengthening life expectancies combined with uncertainty around market returns, and a lack of pensions are factors increasing the likelihood of retirees running out of money during their lifetime

• Planning for longevity risk should include such considerations as determining a realistic personal life expectancy, deferring Social Security, purchasing annuities with lifetime payouts, and carefully choosing a withdrawal strategy from a retirement portfolio

• Longevity risk is one of several risks considered in a comprehensive retirement plan

Longevity risk refers to the risk of outliving your savings, and having to rely solely on Social Security, Medicare, or family members to cover your expenses.  Longevity risk is unquestionably one of the biggest risks facing retirees, if not the biggest. 

In the US, the shift away from employer sponsored pensions (defined benefit plans) to individual retirement savings (defined contribution plans, i.e., 401k) has significantly increased the responsibility for managing longevity risk to retirees.  People planning for retirement now have a greater financial burden and face more risks in managing their post-work income and assets than those who retired before them with pensions.  Complicating matters is the fact that it is impossible to know just how long you will live, and therefore, there is great uncertainty with how long your savings must last to fund your retirement.

In short, increasing lifespans and the shift from employer sponsored pensions to individual plans has increased the need for accounting for longevity risk in retirement planning.

Managing Longevity Risk in Retirement Planning

Planning for longevity risk should include such considerations as: determining a realistic personal life expectancy, working longer, deferring Social Security, purchasing an annuity(s) with lifetime payouts, and carefully choosing a withdrawal strategy from a retirement portfolio.

Estimating Your Life Expectancy

One of the simplest ways to decrease the risk of longevity negatively impacting your retirement is to realistically estimate and plan for how long you are going to live and how long your retirement funds need to last.  Rather than using a general estimate, you can obtain a more accurate estimate by using an online calculator, particularly tools which consider personal information relating to lifestyle, nutrition, medical, wealth, and education – all of which academic studies show are highly correlated with life expectancy.  Estimating Your Life Expectancy is a good source for additional information including available tools.

Armed with more accurate life-expectancy forecasts, you can make better informed judgments about when to retire, claim Social Security, how much to save and spend, and whether to buy an annuity or long-term-care or life insurance.

In simple terms, you should plan to live longer than you think, and adjust your retirement savings plan accordingly.  If you believe you might live until age 90, it is beneficial to plan for living to 92 or 93. Especially with retirement planning, it is recommended you err on the side of estimating too long than too short to avoid outliving your savings.

Working Longer

While not the most popular choice, there are several significant advantages to delaying retirement.  The potential benefits of working longer – even if it’s only part time – include:  increasing your social security benefits, increasing your retirement savings, not having to rely on your savings for as long, continuing to be covered on your employer’s healthcare insurance, and staying socially and mentally active, among others.  Many of these benefits directly and materially reduce your risk of outliving your money.

Income for Life

There are several options available to retirees which provide guaranteed income for life, including social security, annuities, and pension(s) (if applicable).  Making sensible and well-informed decisions regarding these options can go a long way towards mitigating longevity risk in retirement.

Social Security

The benefit of delaying the start of social security benefits cannot be overstated for retirees concerned with longevity risk.  Persons eligible for social security benefits may file for benefits as early as age 62; however, every year you delay your social security benefits, your benefits increase by ~8% each year up until age 70.  If you delay your social security benefits from age 62 to age 70, that is a ~64% increase in social security benefits for life, in addition to cost-of-living adjustments (COLA) that SSA provides each year. 

Delaying social security income may be the single best way to protect against longevity risk.  Social Security benefits are guaranteed to last your (and your spouse’s) lifetime, increase with inflation, are backed by the US government, and do not fluctuate with the financial markets – all highly desirable features to combat longevity risk in retirement!

Annuity(s)

In addition to pension(s) and social security, financial products are available which provide income for life.  A life annuity is an insurance product that pays out a periodic (e.g., monthly) sum of income that lasts for life, in exchange for an up-front premium charge.  However, you should tread carefully as these products may be pushed aggressively within the financial industry, given their high associated commissions.

Investment Strategy

If your retirement is going to last for 20-30+ years, you need to grow your assets to account for both inflation and your longevity.  This requires you to keep a reasonable, age-appropriate portion of your funds allocated in the stock market.  You greatly increase the likelihood of running out of money in retirement with a too conservative investment allocation.

For retirees concerned with longevity risk, a useful rule of thumb may be to target a stock allocation equal to ~120 minus your age.  For example, using this guideline, a 70-year-old retiree would target a stock allocation of ~50% (120-70).  As always, it is important to utilize low-cost investments such as a balanced mutual fund or exchange-traded fund to avoid paying unnecessary investment fees and expenses.

Systematic Withdrawal Strategy

Efficiently and tax-effectively managing withdrawals from your retirement investment accounts is a vitally important component to ensuring your savings last your lifetime.  A well-developed withdrawal strategy will consider personal factors such as your:  income, expenses, investments, and taxes and determine recommended approaches based on your longevity and sustainable withdrawal rates.

Once set, it is important to maintain discipline in adhering to the withdrawal plan and regularly review and monitor your progress against the plan.  It is also critically important to maintain flexibility regarding spending and to have a willingness to make corrective adjustments to your plan as personal and market conditions require, especially in your early years of retirement.

In Closing…

The risk of outliving one’s money – longevity risk – is the biggest concern of most retirees.  Unknown and lengthening life expectancies, combined with uncertainty around market returns, and a significant reduction in employer provided pensions is greatly increasing the risk of encountering longevity risk in retirement planning.   Planning for longevity risk should include such considerations as determining a realistic personal life expectancy, deferring Social Security, purchasing annuities with lifetime payouts, and carefully choosing a withdrawal strategy from a retirement portfolio.

While critically important, planning for longevity risk is just one of several risks associated with retirement planning.  Building a comprehensive retirement income plan to address all risks is a complex process and requires a carefully crafted, balanced set of solutions that requires thought, knowledge, and experience.