The Longevity Risk

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!

By: RetireWare / Equisoft On 8:00 AM

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Life Expectancy

About life expectancy

Life expectancy is the expected (in the statistical sense) number of years of life remaining at a given age.
Life expectancy at birth during the time of the Roman Empire was about 28 years. At the beginning of the 20th century, global average life expectancy was just 31 years, and below 50 years in even the richest countries. Today, life expectancy in Canada and its peer countries is 81 years. This varies widely by region: humans live on average 32 years in Swaziland and 83 years in Japan.

Longevity is positively related to education and income. Longevity is increasing with medical advances and adoption of healthier lifestyles. In fact, life expectancy has increased by a full 10 years in the last 50 years.

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. The increase in life expectancy is expected to continue indefinitely.

Gender differences

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. The gap between men and women has narrowed over time from 7.4 years in 1979 to just 4.5 years in 2009.

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.

Regional differences

Canadians can expect to live three years longer than Americans. This gap has been increasing and this trend is expected to continue in the future.

Life expectancy also varies by region in Canada. While the average life expectancy at birth for the country as a whole was 81.1 in 2009, it ranged from a low of 75.1 years in the territories (Yukon, Northwest Territories and Nunavut) to a high of 81.7 in British Columbia. Three provinces beat the average: British Columbia, Ontario and Quebec.

Healthy life expectancy

The Healthy Life Years indicator (HLY) is a European indicator that measures population health. It combines mortality and morbidity data to represent overall population health in a single indicator. HLY measures the number of remaining years that a person of a certain age is expected to live without disability. In other words, it measures the disability-free life expectancy.

The chart below compares the proportion of a person's life spent in good health for various industrialized countries.

Health-adjusted life expectancy (HALE)

A similar concept related to HLY is the health-adjusted life expectancy (HALE). Life expectancy is sometimes criticized as putting too much emphasis on quantity of life, as opposed to quality of life.
HALE weighs years of life according to health status by subtracting from life expectancy average years of ill-health weighted for severity of health problems.

For example, in 2007 Canada's general life expectancy was 80.7 years, but of those years 73 could be expected to be healthy. So the average Canadian could expect to live about 90% of his or her life in good health.

Interestingly, although women have higher life expectancy than men, men have a higher HALE than women. For 2007, men were expected to spend 88% of their life in good health, compared to 85.8% for women.

The key point is that even if demographers expect HALE to increase in the future, our final years will be  spent with declining health and the associated personal and societal costs of care.

Maximum lifespan

Maximum lifespan refers to the maximum amount of time a member of a species can survive between birth and death. In other words, it is the upper boundary of life.

The oldest confirmed recorded age for any human is 122 years, a feat achieved by Jeanne Calment, a French widow who passed away in 1997. The maximum lifespan of a chimpanzee is 59 years. For a horse, it is 62 years. Here are a few species that have much longer maximum lifespans than us:

Galapagos tortoise	150 years
Lobster	170 years
Koi fish	200 years
Red sea urchin	200+ years
Bowhead whale	211 years
Bristlecone pine	1,000s of years
Jellyfish (Turritopsis nutricula)	Immortal
Hydra	Immortal

Immortality is possible! The cells of hydras continually divide and this allows defects and toxins to be diluted. They do not undergo “senescence”, and, as such, are biologically immortal. Turritopsis nutricula is a small (5 millimeters) species of jellyfish that converts its cells (transdifferentiation).  This process can repeat indefinitely, also rendering it biologically immortal.

Leading causes of death

Alas, we do not possess the genetic qualities for living such a long time. How can we make the most of what we have? The answer seems to lie in what we eat and the amount of physical activity we do.

According to the U.S. National Vital Statistics Reports (Vol. 60, No. 4), the leading causes of death in 2010 were diseases of the heart and malignant neoplasm, each accounting to about 25% of deaths. Chronic lower respiratory diseases, cerebrovascular diseases and accidents accounted for about 5% each of the deaths. The rest was attributed to other causes, each amounting to a 2.5% or less.

"Uprooting the Leading Causes of Death" is an excellent – and entertaining – video by Dr. Michael Greger that offers practical advice on how best to feed ourselves to prevent, treat, and even reverse many of the top 15 causes of death.

• Watch "Uprooting the Leading Causes of Death"

Dr. Greger has a Website called nutritionfacts.org, which disseminates nutrition-related research published in scientific journals in short, easy to understand video segments.

[Try our life expectancy calculator. You will get access to it with your free RetireWare account.]

[In addition to Statistics Canada, a lot of information and facts were based on “How Canada Performs” by The Conference Board of Canada at http://www.conferenceboard.ca/hcp/details/health/life-expectancy.aspx#ago]

By: RetireWare / Equisoft On 4:27 PM

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Data Security

Question:

I'm a bit concerned about having personal data stored on-line. How accessible is that data to both Retireware employees and general public?

Answer:

All data is encrypted when stored to the database and decrypted only at time of use by the RetireWare application.

So the database administrators, who have access to the database, would only see encrypted data fields and have no way of making sense of the data.

Similarly, while there are numerous security measures to prevent hackers from getting access to the database, should it ever occur, all they would get is encrypted data.

Data is stored using a powerful encryption algorithm that meets the Advanced Encryption Standard (AES), a specification for the encryption of electronic data established by the U.S. National Institute of Standards and Technology (NIST). AES has been adopted by the U.S. government and is now used worldwide.

The encryption algorithm we use is almost impossible to decrypt.

In any case, we will never access your data unless you give us permission to do so to handle a support request.

There is more information on our security page:

https://secure.retireware.com/security.aspx

By: RetireWare / Equisoft On 9:38 PM

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Income Tax

Question:

I have noticed that Retireware will calculate a decreasing amount of income tax payable annually.

What are the underlying assumptions for calculating income taxes? Does the program use current year income tax rates and income brackets, and then escalate the income brackets with inflation?

Answer:

The program calculates income tax based on the current year rates, thresholds and deductibles, and assumes escalation of brackets even for provinces that do so on an ad hoc basis.

By: RetireWare / Equisoft On 10:51 AM

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Variable Rates of Returns

Question:

Does the software have the capability to change projected rates of returns over the course of the calculation. For example, can you put in a return of 2% for say the first 3 years, then increase it to 3% for a few years and then 5% for the remainder?

Will it give me the maximum spending if I want to have 0 left at age 95?

Answer:

The expected rates of returns are fixed, but you can set an asset mix that changes at retirement or an asset mix moves gradually to a more conservative portfolio over a set number of years.
So, yes the weighted rates of return can change over time, but using a structured approach based on the allocation of your assets to cash, fixed income and equities.

The program does not calculate maximum spending, but you can adjust your income goal and recalculate, until assets are exhausted or nearly exhausted at the desired age.

Please note that you cannot set your own expected rates of returns if you are using the free version.

By: RetireWare / Equisoft On 10:49 AM

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CPP Not Showing

Question:

I have selected CPP and selected it as a source of income for my spouse and I and filled in all fields, but no CPP payments are reflected in the cash flow summary.

Answer:

If you indicated that you are already retired in 'Financial Information', then you should also include for your spouse and yourself an annual income because the CPP needs this to calculate an estimate. The annual income will be used only for the CPP estimate.

By: RetireWare / Equisoft On 10:47 AM

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The Sequence of Returns Risk

When things don't go according to plan

The sequence of returns risk is the risk of incurring low or negative investment returns in the early years of retirement and the erosion of the asset base caused by withdrawals, making it is difficult to recover even if you have strong returns in the following years.

In other words, if you incur a couple of years of low or negative returns while taking withdrawals,

your ability to make up losses in future years even with strong investment returns is greatly diminished.

This is more acute with equities, which are more volatile than fixed income investments -- equities' higher expected returns come at the price of taking more risk. Investment returns from equities have greater variability, with large swings from one year to the next.

The following chart illustrates the volatility of returns of various asset classes.

The blue line represents annual returns on cash and money market investments over the last 20 years.

Returns are low and predictable. The red line shows annual returns for a bond portfolio. Less stable returns from year to year, but still fairly consistent.

The green line shows returns of the S&P/TSX Total Return Index, representing Canadian stocks. This green line zigzags wildly each year going from good to bad.

The returns in the above chart do not take into account fees and come from Canadian indices for cash, fixed income and equities.

If you're invested heavily in equities at the onset of retirement, timing is everything. If you're unlucky and start at a time when the green line goes south, your portfolio may never recover and you will run out of money faster than if you get decent investment returns.

Sequence without consequence

Consider these three possibilities of getting an average 7% return:

• Level: 7% each year
• Lucky: returns of -10%, 7%, 27.2% each year repeated every three years
• Unlucky: returns of 27.2%, 7%, -10% each year repeated every three years

If you take no withdrawals, you'll end up with the same balance. The order in which you earn the return does not matter: you'll end up with the same amount of money.

This is good news during the accumulation phase in view of retirement. Years of negative returns will be made up with good years and you'll earn the average of the asset class you are investing.

 

Where sequence matters

When you take withdrawals sequence greatly matters. In our example, starting with $100,000 and taking $10,000 per year, the lucky order will let your assets last 21 years, while the level return will go for 17 years. However, the unlucky sequence will only last 14 years.

 

What you can do

Of course you can't know whether your retirement will start on a year with good investment returns. So these are a few strategies to consider in order to minimizing or avoiding the sequence of returns risk.

Reduce exposure to equities

While keeping some of your assets equities is essential to boost long-term returns, retirement is not the time to bet the farm. Having a significant portion of your funds invested in fixed income will damper the impact of an undesirable sequence of returns.

No equities

Having no equities will make the problem disappear, but creates another one: without the strong average returns of equities, you may not earn enough investment income to fund your retirement.

A moderate amount of risk is the trade-off required to earn these higher expected returns, while keeping the bulk of your assets in less volatile and risky assets, for example fixed income.

Invest conservatively and diversify

Lowering exposure to equities is a sensible approach, but you can also imnprove your odds on the equity portion of your portfolio by investing in companies that are not speculative. If you can't afford the consequences of bets that don't pan out, then you should stay away.

A diversified portfolio that closely follows the index will work best to take away company-specific risk, so your exposure is only to market risk.

Stay invested

If you suffer low or negative returns, stay invested. You can't throw the towel or know ahead of time what will happen next.

Time horizon

Look at your time horizon for the investment. If it's only a few years, equities may not be a good fit because you don't have time to make up losses. If it's for a longer term, such as 20 or more years, you'll live through a few bull and bear markets and earn the average return of that asset class.

Spend conservatively

Spend conservatively during the first few years of retirement and minimize your withdrawals. If you earn poor returns, low withdrawals will not deplete your assets as much and you'll be left with enough funds for the rest of your retirement.

Adapt spending

If you have a year with negative returns, take less for the following couple of years to help minimize losses and keep as much money invested to earn more investment income when markets recover.

Get an annuity

An annuity will not only eliminate the sequence of returns risk, but also the longevity risk. Consider annuitizing part or all of your assets. Partial annuitization works best if you plan to leave money to your estate.

Segregated fund with income

Some insurance companies offer a "guaranteed minimum withdrawal benefit" (GMWB), which is an option to provide an income for life, usually between 3% and 5% per year of the capital invested in the product.

The amount upon which the withdrawal rate is based is usually reset every few years, so if there are good investment returns, the income can grow (but never decline). You can read more about it at the end of this recent blog post.

By: RetireWare / Equisoft On 11:03 PM

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