This article is part of a series; click here to read Part 1.
The fundamental risk for retirement is unknown longevity,
which is summarized in the question, how long will your retirement plan need to
generate income? It is the risk of running out of assets before running out of
time. The length of retirement could be much shorter or longer than the
statistical life expectancy. A long life is wonderful, but it is also costlier
and a bigger drain on resources. Half of the population will outlive their
statistical life expectancy, and that number is only increasing as scientific
progress increases the number of years we can expect to live. For some
retirees, the fear of outliving resources may exceed the fear of death. This
can create a paralyzing effect on retirement spending.
When determining longevity, it may seem natural to base calculations on the aggregate US population, but clear socioeconomic differences have been identified in mortality rates. Higher income and wealth levels and more education each correlate with longer lifespans. This may not be a matter of causation (i.e., more income and education cause people to live longer), but perhaps an underlying characteristic leads some people to have a more long-term focus, and that, in turn, may lead them to seek more education and practice better health habits. The very fact that you are reading this somewhat technical tome on retirement income suggests you probably have a longer-term focus and can expect to live longer than the average person. In this case, mortality data based on population-wide averages will underestimate your longevity.
Not everyone will live longer, as unfortunate accidents and
illnesses will inevitably befall some along the way. But in a statistical
sense, my average reader will live longer than the average person.
The American Academy of Actuaries and the Society of
Actuaries created the Longevity
Illustrator to help users develop personalized estimates for their
longevity based on a few questions about age, gender, smoking status, and an
overall assessment of health. It is a free and simple-to-use resource. Exhibit
1.1 provides its output for sixty-five-year-old males and females based on
their health assessment and smoking status.
Exhibit 1.1: Planning Ages for Sixty-Five-Year-Olds from the Longevity Illustrator
In a probability-based world, the available means for an
individual to manage longevity risk is to choose a conservative planning
horizon for which there is a sufficiently low probability to outlive. This will
require spending less so that available assets can be drawn out for a longer
period of time. The probability of surviving to advanced ages is low.
Individuals must determine how low a level of spending they are willing to
accept today in their effort to plan for a longer life and better ensure that they
will not deplete their assets before death.
For example, a nonsmoking sixty-five-year-old female in
average health who is willing to accept a 10 percent chance for outliving her
financial plan would want her plan to work to age ninety-nine. For a male with
the same characteristics, age ninety-seven corresponds to accepting the same
amount of longevity risk.
In 1994, William Bengen chose thirty years as a conservative
planning horizon for a sixty-five-year-old couple when he discussed sustainable
retirement spending. But as mortality improves over time, this planning horizon
is becoming less conservative, especially for nonsmokers in reasonable health.
The Society of Actuaries (SOA) also produced the 2012
Individual Annuity Mortality tables that I think will appropriately reflect the
situation for my readers. Compared to the Longevity Illustrator numbers shown
in Exhibit 1.1, the individual annuity mortality table corresponds with data
for nonsmokers in average to good health. And this data set provides mortality
rates at all ages, making it useful for supporting other annuity calculations.
This mortality data is specifically for annuity purchasers who tend to live
longer than average. For instance, those with significant illnesses tend to
avoid buying annuities. The data also reflects estimates for future mortality
improvements and is not based only on the situation in one year.
Exhibit 1.2 uses this data with mortality improvements
projected for a starting year of 2019 to illustrate longevity risk by showing
the probability of survival to different ages beyond sixty-five. It also shows
outcomes for a couple’s joint longevity. With retirement planning, the trouble
is knowing what age to plan for, as this distribution of potential retirement
lengths is quite wide. With this data, the probability of a sixty-five-year-old
reaching age ninety-five is 23 percent for males, 30 percent for females, and
46 percent for at least one member of an opposite-gender couple. For a couple,
thirty years is getting close to being the life expectancy for its longest
living member. The probability of outliving a thirty-year time horizon is not
insignificant. Longevity risk is the risk of living longer than anticipated and
not having the resources to sustain spending for a longer lifetime. It is
reflected in the exhibit as if one builds a plan to work through age
ninety-five but then lives past this age.
Exhibit 1.2: The Probability of Survival from Age Sixty-Five and the Longevity Risk for a Planning Age of Ninety-Five
This article is part of a series; click here to read Part 3.
Source: Own calculations for Society of Actuaries 2012 Individual Annuitant Tables with improvements through 2019.This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon.
Originally posted at https://retirementresearcher.com/changing-risks-in-retirement-pt-two-unknown-longevity/