Friday, December 21, 2012

The Longevity Risk

8:00 AM

What is the longevity risk?

The longevity risk is the risk attached to the increasing life expectancy, which can eventually translate in needing higher than expected funds to meet expenses during retirement.

In other words, as you spend down your savings during retirement, if you live longer than expected you will run out of money. This means your last days could be spent in poverty or as a burden to relatives.

Getting lifetime income

In 1965, Jeanne Calment, a 90-year old French widow, sold her apartment to a lawyer under a contingency contract. The contract provided that he would pay her 2,500 Francs per month until her death, at which point the ownership of the apartment would be transferred to the lawyer. Unfortunately for the lawyer, Jeanne Calment turned out to be the world’s longest living human and survived for another 32 years.

The Canada Pension Plan and Old Age Security provide similar guarantees, but do not provide sufficient income for most. Those fortunate enough to accumulate long service in an employer-sponsored defined benefit pension plans get a lifetime guaranteed income, which together with Government pensions will typically generate sufficient income.

Getting guaranteed lifetime income is the key to eliminating the longevity risk. Without it, as one gets older and see savings dwindling down, the only strategy is to tighten the belt and conserve money until only Government pensions remain.  

We are living longer

The life expectancy at birth in Canada was 81.1 years in 2009. Life expectancy has increased by 6.2 years since 1979, when it was 74.9 years. Life expectancy has been steadily increasing and the trend is expected to continue. The upward trend in longevity is good news for all of us. Medical advances, reduction in smoking, exercise and a better diet are having a big impact on life expectancy. From a financial point of view, increased longevity puts a stress on individuals and Government. 


Women tend to have a lower mortality rate at every age. Life expectancy at birth in Canada in 2009 was 78.8 years for men and 83.3 years for women.



How long will I live?

A recent report from the Society of Actuaries (“2011 Risks and Process of Retirement Survey”) finds that more than half of retirees and pre-retirees misjudge their life expectancy and about 40% underestimate the figure by five or more years. Underestimating life expectancy means having too short a planning horizon. This can result in inadequate provision for retirement needs.
“Even when individuals or couples do make a reasonably good estimate of remaining lifetime for people their age, far too few of them provide adequately for the consequences of out­living average life expectancy.” – Society of Actuaries
Another shortcoming noted in the report is failing to fully understand the variability in life expectancy, and to understand that about half of the people will outlive the average life expectancy. Average life expectancy at age 65 is in the mid- to late 80s. For a 65 year old couple, there is a 50% chance that one will be living to age 91 and a 25% chance that one will be living to age 95.

At retirement, the steady stream of employment earnings that many of us relied upon stops and is replaced with withdrawals from assets accumulated to finance the rest of our lives. We face an uncertain future: we cannot know how long we will live or how healthy we will be. The first step is to ensure we don't underestimate our life expectancy when planning retirement.

Managing the longevity risk  

Running out of money is one of the primary concerns of most retirees. This is an even larger concern today as life expectancies have risen. Planning to live to a specified age is risky, and planning to live only to your life expectancy will be inadequate for about half of us.

There are three main approaches to creating lifetime retirement income:

  • Systematic withdrawals,
  • Annuities, and
  • Segregated funds that provide a guaranteed minimum lifetime benefit (GMWB).

Systematic withdrawals

Managing your retirement funds over a lifetime is a difficult balancing act. Being cautious and spending too little might needlessly restrict your lifestyle, and spending too much increases the chance of running out of money.

Managing the longevity risk means planning for a long period. Part of your assets should continue to be invested in equities, which have historically achieved higher returns, despite having higher volatility. The long-term horizon of your retirement – 20 or 30 years, means that you can ride out the ups and downs of the market by staying invested.

Poor returns in equity markets have set back retirement savings considerably and investors have responded by taking shelter away from equities to more conservative investments. Abandoning equities completely severely limits return potential and lower returns can seriously affect the amount and duration of retirement income.

Look at the odds of living longer than average and ensure you have the financial resources to meet your expenses for this entire period. If your resources are insufficient, scale back your retirement lifestyle as much as you can, especially in the early years.

With systematic withdrawals you are retaining the longevity risk. You can only mitigate its impact by scaling back withdrawals and achieving better investment returns. The advantage is that you keep control of your money and can leave a legacy.

Annuities

The alternative of getting a life annuity eliminates the longevity risk altogether and provides an income stream for life. There are some disadvantages: losing control of your assets and the ability to leave money to heirs. Annuities can be expensive and provide an income that may not be sufficient to cover all expenses. This can make annuities slightly unpopular, but they should be considered as an important tool for retirement planning.

Instead of purchasing an annuity once, consider laddered purchases every few years. The income will be higher, and you will have a better idea of your longevity prospects. If you are healthy, the annuity rates will be higher, but you will keep control of a portion of your assets for a longer period of time. You can factor your desire to leave a legacy in deciding how much to allocate to an annuity.

GMWB

Some insurance companies offer a "guaranteed minimum withdrawal benefit" (GMWB) option with their segregated funds. The GMWB provides an income for life, usually between 3% and 5% of the invested capital. The amount upon which the withdrawal rate is based is usually reset every few years, so if there is good investment returns, the income can grow (but will never decline).

These products have many complex rules (and terminology) and are sometimes difficult to understand. They also often “lock-in” the investor, who has to stay with the strategy or face penalties and losses if they cash out before the end of the term.

Many insurance companies have recently suspended sales of these products. Those who haven't suspended sales have reduced the lifetime income payout from 5% to 4% or even 3% to ensure their viability. The lower payout rates make these products less attractive at this time.

Which is best?

The solution may lie in a combination of these approaches. In any case, these three approaches of generating retirement income have different, sometimes opposite, features that involve trade-offs between flexibility and control in exchange for lifetime security.

There are some mathematical models that find the combination of these three products that minimizes the odds of running out of money while ensuring estate goals are met. When the models are used in a commercial context, we have to take the recommendations with a grain of salt: in the end, the objective is to sell product.

Not yet retired?

If you’re not yet retired, you can address the longevity risk by saving more, investing more aggressively, postponing retirement or planning for a lower standard of living for a longer period.
Saving more is paramount. Stash away as much as you can. Taking more risk with your investments may or may not work in the short term, but history has shown that well-diversified equities will outperform other asset classes over the long term.

Postponing retirement can be an attractive option to enhance retirement preparedness or recover from investment losses. Research has shown that the impact of delaying retirement from age 62 to age 66 can increase retirement income by 33%.

Postponing retirement reduces the odds of running out of retirement savings in several ways:

  • Additional savings accumulated,
  • Additional returns earned on savings,
  • Untouched capital that otherwise would be paid out as retirement income,
  • Increased value of other sources of retirement income such as Government and public pensions and employer-sponsored savings plans, and
  • Shortened post-retirement period.

Planning for a lower standard of living may be a last resort strategy, when all other options have been exhausted.

If unforeseen circumstances cause you to retire earlier than intended, consider working part-time or on a contractual basis during retirement.

Conclusion

We most likely will live longer than we think. Longevity is variable, and averages can mislead. One spouse will outlive the other and live for several years. Living long is expensive, but is an insurable risk with annuities. While other strategies reduce or mitigate the longevity risk, annuities take the risk away.

Longevity is a risk that I hope we will all have to deal with!

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